Tax and Business Alert - April 2004

Qualified Tuition Programs

It seems that with each passing year, the cost of a college education continues to climb at an alarming rate. Meanwhile, parental concern about how to pay for that college education also continues to increase. A qualified tuition program (QTP), often referred to as a Section 529 plan, may be a welcome source of relief to many nervous parents and students as well.

QTPs merit serious consideration as a source of funds for that college education. They have become increasingly popular and the tax benefits are better than ever. These programs enable a person to (a) prepay tuition benefits on behalf of a beneficiary or (b) contribute to a college savings account that is established for paying a beneficiary's higher education expenses. A prepaid tuition QTP is best thought of as a way to lock in the price of covered educational services at today's prices. In contrast, a savings QTP is best described as a tax-advantaged way to build up a college fund. For both types of plans, the federal tax advantages are identical.

All 50 states now offer these programs, and most are available to nonresidents. The beneficiary can use the funds accumulated in the plan to attend any U.S. college or university.

The most important tax advantage is that funds grow tax-free while in the QTP and can be withdrawn tax-free to pay for qualified higher education expenses. Also, while there are no federal income tax consequences for contributions, many states allow residents to claim a state income tax deduction or credit for contributions to in-state QTPs.

Although a transfer to a QTP is considered a gift, the transfer can be offset by the annual gift tax exclusion of up to $11,000 in 2004. Additionally, a special rule allows contributors to spread transfers over five years for gift tax purposes. This would allow an individual to contribute up to $55,000 ($110,000 for a couple that elects to split gifts) in 2004 to a QTP without any gift tax consequences (assuming no other taxable gifts are made to that beneficiary for a five-year period).

These programs, especially prepaid plans, may affect the beneficiary's ability to qualify for federal financial aid as well as aid offered by a college or university. (Note that 529 savings plan accounts owned by grandparents generally do not affect a student's eligibility for loans or aid.) This is a very important consideration that should not be overlooked.

The tax rules allow QTP owners a good deal of flexibility (for example, the ability to change investments and beneficiaries). However, QTPs are not required to offer all the flexibility advantages permitted by the tax law. The specific features of any QTP should be verified before you begin investing. Information on QTPs can be found on the Internet at www.collegesavings.org.

Tax Calendar

April 15
- Besides being the last day to file (or, extend) your 2003 return and pay any tax that is due, 2004 first quarter estimated tax payments for individuals, trusts, and calendar year corporations are also due today. So are 2003 returns for trusts and calendar year partnerships and LLCs, plus any final contribution you plan to make to a traditional or Roth IRA or Education Savings Account for 2003. (SEP and Keogh contributions are also due today if your return is not being extended.)

- If you need to file a 2003 gift tax return, it also must be filed or extended by this date.

April 30
- For those with employees, a federal unemployment tax (FUTA) deposit is due if your employment taxes (FICA and withheld income taxes) liability is $2,500 or more and the FUTA liability through March 31 exceeds $100.

-The first quarter Form 941 (Employer's Quarterly Federal Tax Return) is also due today (except that you have until May 10 to file if you deposited all taxes for the quarter when they were due).

June 15
- The second quarter estimated tax payments for individuals, trusts, and calendar-year corporations are due today.

Employee Benefits Website

Employee benefit plan sponsors as well as service providers and participants can find helpful compliance information and tools at http://www.benefitslink.com.

As an independent publisher, BenefitsLink combs the Web daily for articles on compliance matters and then posts them by date or topic under "Benefits Buzz." Online sources include newspapers, professional journals, government agencies, and newsletters from various corporations and foundations. The website's features include links to source documents, Q&A columns, information on conferences, a bookstore, speaker's database, message boards, and job postings. Users can also receive two free daily e-newsletters that cover retirement plans and welfare plans.

Deducting IRA Contributions

You may be eligible to contribute and deduct up to $3,000 ($3,500 if age 50 or older by December 31) in Traditional (not Roth) IRA contributions on your Federal income tax return. However, these deductions are subject to several limitations. First of all, the IRA contribution and deduction amount is limited to your total compensation for the tax year. So, if you're total compensation is $2,353 that is the maximum possible contribution and deduction allowable.

Next, when you (or your spouse, if married) are covered by an employer-sponsored retirement plan, your Adjusted Gross Income (AGI) will determine the maximum deductible amount of your IRA contribution. This limit doesn't affect the maximum contribution amount, just the amount that is deductible. Also, you can always deduct your full contribution (up to the maximum allowed) if you (or your spouse, if married) are not covered by an employer-sponsored retirement plan.

If married, both spouses may be eligible to make a tax-deductible contribution of up to $3,000 each ($3,500 if age 50 or older by December 31), even if only one spouse has income.

Reduce Estate Taxes with a Credit Shelter Trust

If married, you can reduce your taxable estate, upon which the federal estate tax will be calculated, by the amount of assets transferred to your surviving spouse using the unlimited marital deduction. Marital deduction property must be property that would have been included in your estate and may be passed to your spouse either outright or in certain qualifying trusts. The benefit of this asset transfer is to eliminate any federal estate tax on the assets transferred to your spouse at the time of your death.

Even though the unlimited marital deduction can eliminate federal estate taxes on the estate of the first spouse to die, it may cause an unnecessarily higher tax on the second spouse's estate because the marital deduction property from the first estate must be included in the second. In addition, transferring all property to the surviving spouse would deprive the first estate of a significantly valuable credit, i.e., the applicable credit amount. The applicable credit amount was put in the law to exempt smaller estates from the federal estate tax. The credit is worth $555,800 (in 2004) and represents the federal tax due on the first $1.5 million of federal estate taxable assets.

The effect of the $555,800 credit is that $1.5 million (in 2004) of assets can permanently escape the federal estate tax. The $1.5 million applicable exclusion amount will gradually increase to $3.5 million by the year 2009 before the federal estate tax is repealed in 2010. Property worth the applicable exclusion amount can be transferred to a credit shelter trust for which the spouse can be the income and limited corpus beneficiary. The trust's terms, including the spouse's beneficial interest and choice of trustee, must be planned carefully to result in the highest benefit, taking the couple's circumstances and wishes into consideration.

Your combined federal estate tax can be significantly reduced if your wills allow each of you the maximum use of the applicable credit amount by using a credit shelter trust as shown in the following example.

Example: Assume that Mike dies in 2004, leaving his entire $3 million estate to his wife Stephanie who has assets of $500,000 at that time. Mike's estate would have no federal estate tax to pay because the unlimited marital deduction reduces his estate to zero. However, Mike's $3 million estate plus Stephanie's $500,000, plus any appreciation, would be included in her estate when she dies. Of course, Stephanie would be entitled to the applicable credit amount at her death. So, if she died in 2006 and the property had not appreciated, the federal estate tax on $3,500,000 would be $690,000.

If Mike and Stephanie's wills had provided for a credit shelter trust, Mike would have transferred $1.5 million (the applicable exclusion amount for estates in 2004) into it and the remaining $1.5 million to Stephanie, either outright or in trust. The combination of the applicable credit amount and marital deduction would still result in no federal tax on his estate. Here's the beauty of the applicable credit amount. When Stephanie dies in 2006, her estate is $2 million ($500,000 plus the $1.5 million marital deduction property from Mike) assuming no appreciation. Because the applicable exclusion amount is $2 million for 2006, her estate pays no tax, and $690,000 of federal estate tax is eliminated.

As illustrated above, every married couple with an estate valued above the applicable federal exclusion amount ($1.5 million for 2004) should consider a credit shelter trust.

Work-Related Fringe Benefits

Most employees think of health insurance and retirement plans as their fringe benefits. However, there are several types of fringe benefits collectively known as work-related fringe benefits (or Section 132fringe benefits) that are also available to many workers. The value of an employer-provided work-related fringe benefit is generally excluded from an employee's income, subject to specific limitations and restrictions. Work-related fringe benefits include:

Qualified employee discount programs:
A price reduction (discount) on an employer's product or service generally offered to outside customers in the ordinary course of business in which the employee performs substantial services can generally be excluded from the employee's income. The discount cannot exceed the employer's profit margin on property or 20% of the employer's selling price on services.

No-additional-cost services:
The cost of a service provided by an employer for employees can generally be excluded from the employee's income if (a) that service is normally offered to outside customers in the ordinary course of the business line in which the employee performs services and (b) the employer incurs no substantial additional cost to provide that service to the employee. However, only excess capacity services such as hotels; transportation by aircraft, train, bus, subway, or cruise line; or telephone services are eligible for this exclusion.

Working condition fringe benefits:
These benefits include property or a service provided to an employee where the employee could have deducted the cost as a trade or business expense. Examples include magazine subscriptions, professional dues, and business travel and entertainment.

De minimis fringe benefits:
De minimis fringe benefits include goods or services that have a small (nominal) value where accounting for the item is unreasonable or administratively impractical. Generally, providing employees with cash or gift certificates does not qualify as a de minimis fringe benefit.

On-premises athletic facility:
Eligible employees can use an on-premises tennis court, gym, or swimming pool provided by an employer on a tax-free basis.

Other benefits:
Subject to limitations, the cost of qualified commuter transportation, transit passes, parking, moving expense reimbursements and retirement planning services (provided to an employee or spouse by an employer maintaining a qualified employer plan) are excludible from the employee's income.