Tax and Business Alert - July 2002

Financial Tune-ups

Like a car that runs better with routine maintenance, your financial life should operate smoother with regular attention. As income taxes are a significant factor in most taxpayers' budgets, we want to focus here on ways to hold down your tax liability. We only have room to give you a few suggestions, so call us if you'd tike to discuss these or others.

FOR YOUR BUSINESS

·           New assets. There's no question we're in a tough economic environment, but hopefully better days are just around the corner. As income and revenue pick back up, one thing businesses can do to hold down tax liabilities is maximize the deductions available from buying new assets. For example, a business that acquires $100,000 of new seven-year property can generally claim an expensing (Section 179) deduction of $24,000, 30% bonus depreciation on the remaining $76,000 of costs (i.e., $22,800), and regular first-year depreciation of $7,602 on the balance of costs (for a total first-year reduction of $54,402).

·           Retirement plans. If your business doesn't offer a retirement plan, it may be time to take the plunge. With recent improvements to the tax benefits of retirement plans, you owe it to yourself to get serious about saving for retirement. Call us and we'll help you figure out where to start and how to get Uncle Sam to pick up part of the cost.

·           Accounting method. A business' overall accounting method can have a big impact on when it pays tax on its income. The cash method is generally the most favorable (and simplest), but a lot of businesses in the past had to use the accrual  method because they had inventories. Within the last few months, however, the IRS has significantly relaxed the rules for using the cash method for certain businesses with no more than $ 10 million of average annual revenue.  If your business is within this limit and uses the accrual method, it might be worth seeing if it qualifies for (and would benefit from) the cash method.

AND FOR YOU

·          Investment transactions. With the stock market's continued gyrations, now's a good time for investment planning. For example, consider selling enough losers to offset any capital gains you've realized. Plus, up to an additional $3,000 of losses ($1,5OO on a married filing separately return) can offset ordinary income. If you have gains you'd like to lock in on assets owned more than a year, consider donating the asset to charity. This normally yields a deduction for the property's full value without having to recognize any of the gain.

·          Retirement contributions. Fund your IRA and other contributions as early in the year as possible to maximize the tax-deferred or tax-free benefits of the income. If you have a sideline business, also consider setting up a retirement plan and making contributions based on that income.

·          Education expenses. If you have children headed to or already in college, don't overlook the tax advantaged ways to save and pay for their education. With the revamped Coverdell Education Savings Accounts, we now even have a tax-advantaged way to save for K- 12 expenses of private or public school. Call us if you'd like to go over the available options for saving for college and see the article on page 3 related to paying for college.                  

TAX CALENDAR UPCOMING TAX DEADLINES

July 31--A federal unemployment tax deposit is due if the undeposited liability through June exceeds $ 100. In addition, the second quarter Form 941 1Employer's Quarterly Federal Tax Return) must be filed by today, unless all taxes for the quarter were deposited in full and on time (in which case the deadline is extended to August 12). And finally, Form 5500 is due (unless an extension is filed) for most calendar-year employee benefit or pension plans.

August 15--Personal returns extended to April need to be filed or extended (to October 15) by today.

September 16--Third quarter estimated tax payments are due for individuals, trusts, and calendar-year corporations.

If a six-month extension was obtained, calendar-year corporations should also file their 2001 income tax returns by this date.        

TAXPAYER WINS: DEDUCTION OKAYED!

In a recent Tax Court decision, the IRS failed in its attempt to make a company change its long-standing practice of expensing certain items. The key issue was whether the IRS could require the company to capitalize and depreciate these items.

 As part of its business, the company provided customers with dust control items (i.e., towels, linens, mats, and mops) and industrial garments worn by the customers' employees. The IRS argued that the useful lives of these were greater than one year, and, thus, their cost had to be capitalized and depreciated over the items' useful lives. The IRS relied on the assets' physical lives, the company's service contract terms, and statistical analysis to support its argument. The company, however, was able to show that although the items physically lasted more than one year, the amount of time the garments were actually in use was less than or not substantially in excess of one year.

The Court concluded that the IRS didn't have the authority to make the company change its method of accounting because expensing the items' costs when placed in service clearly reflected the company's income and expenses. Additionally, the Court noted that the company's method was appropriate because it reflected generally accepted accounting principles, was an accepted practice in the industrial laundry business, used a reasonable approximation to determine a useful life of less than one year, and treated the expense of garments and dust control items consistently from year to year.

Way to go Tax Court! Score one for the taxpayer.

INTERESTING WEBSITES

On the move.  If you're one of the millions of Americans who will be moving to a new home this summer, check out the United States Postal Service's website at www.usps.gov/moversnet. Not only can you file a change of address form online, the site also includes a host of other useful information-from statistical data about your new neighborhood, to help in switching your phone or internet service provider. You can also find numerous moving tips, as well as referrals to banking, insurance, utility, and other service providers who offer their services in your new zip code area.

Medical news. The publisher of the Physicians' Desk Reference (one of the most widely used sources of health and drug information for doctors and other health care professionals) offers a consumer-oriented website (www.gettingwell.com) full of useful information about hundreds of medicines. In addition, the site includes an overview of the more common diseases and a listing of clinical trials and results for various medicines.

TAX SCHOLARSHIPS

When your son or daughter goes off to college, wouldn't it be nice if you could get Uncle Sam to pick up a significant part of the costs? Of course, depending on your circumstances and the college chosen, you or your child may be eligible to receive a combination of loans and scholarships--some of which come from the federal government. However, that's not what we're talking about here. What we want to do is show you how to get Uncle Sam to help pay for a portion of what would otherwise be your out-of-pocket costs.

PAYING FOR COLLEGE

With the tax law changes made in the last several years, we now have several tax-favored methods of helping your finances survive the college years. Here's a quick summary of some of the better options.

· Hope tax credit. For married taxpayers with adjusted gross income of no more than $102,000 ($51,000 for singles), a tax credit of as much as $1,500 is normally available for up to the first $2,000 of a child's tuition in any two years in which the student is classified as a freshman or sophomore. If your income is too high to qualify for the credit, you may be able to indirectly benefit from the credit by letting the student claim it.

· Lifetime learning credit (LLC). Using the same adjusted gross income limits as above, this credit equals 20% of the first $5,000 of qualifying expenses (20% of the first $10,000 beginning next year). Unlike the Hope credit, the LLC is available for any of the college years (although it may not be combined with the Hope credit for the same student in a single year). Because the LLC only yields a 20% credit, some taxpayers with business-related educational expenses will be better off skipping the credit and claiming the expenses as a business deduction--something that frequently yields a better than 20% income (and, in some cases, self-employment) tax deduction.

· Educational assistance plans. Employees can annually receive up to $5,250 of tax-free educational assistance from their employers. Thus, if you own a business and employ your family's college-age student, a significant portion of the student's educational expenses might be a valid business deduction. We say "might" because the assistance plan must be nondiscriminatory, and no more than 5% of its benefits can go to the business owners or their spouses or dependents. That's the bad news. The good news is the 5% rule doesn't apply to children who are at least 21 and no longer your dependent.  Thus, once the kids reach 21, through a combination of deductible wages and tax-free tuition payments, you may be able to turn all of their continuing educational expenses (for graduate school, etc.) into a tax deduction. For children under age 21, employing them in the business and having them spend at least part of their earnings on their own education can still allow you some deduction for their college expenses.

·Transferring appreciated capital assets to the student. Gifting appreciated stock or mutual fund shares to a child who later sells them at his or her normally very low tax bracket can create more after tax funds for college than if you keep the shares and sell them yourself. Even a transfer of assets such as certificates of deposit can make sense if the child saves the transferred asset and related future income to use for college expenses. Because of the new 10% income tax rate, such ordinary income is generally taxed at a much lower rate than if reported on your return.

·Higher education tuition deduction. Taxpayers with no more than $130,000 of adjusted gross income on a joint return (or $65,000 for singles) can claim up to a $3,000 deduction for qualified tuition. (The deduction isn't available if you're already claiming the Hope or Lifetime learning deduction for the same student in the same year.)

CONCLUSION

With a little effort, there's generally a way to directly or indirectly secure a tax benefit from at least a portion of your children's college education costs. The key is to understand the available options and plan far enough ahead to take advantage of the ones that are right for you. In addition, with children who will be eligible for financial aid (and most will be eligible for at least some), you want to make sure any savings generated by tax planning aren't more than offset by a decrease in the amount of gift/grant-based aid your child would otherwise receive.                

IRA WITHDRAWALS

The IRS recently finalized the rules that determine how much you must take out of your traditional IRAs annually beginning no later than the year after you turn age 70 ½. Although not officially effective until 2003, the IRS says you can use the new rules this year (in lieu of either of the two sets of interim rules issued earlier).

NEW LIFE EXPECTANCY TABLE

The amount of each year's required distribution depends on the account balance at the end of the previous year divided by a life expectancy divisor. The younger you are, the bigger the life expectancy divisor. The bigger the divisor, the lower the required amount. Of course, low is good if you want to maximize your IRAs' tax-deferral advantages and minimize the tax you owe each year because of the distribution.

The biggest change in the final rules is that they update the Life Expectancy Table to reflect the improved life expectancies of recent years. As a result, for a given age, the life expectancy divisor is larger and the required distribution is lower than under the previous rules.

Example I: Phyllis, who is single, turns 70 ½ this year. She will still be age 70 at the end of the year. Her traditional IRA balances at the end of last year total $250,000. To determine the amount she must take out this year (or by no later than April 1 of next year because this is her first year of required distributions), divide the $250,000 by 27.4 (the life expectancy divisor for a 70-year-old person). The answer is: $9,124 ($250,000 ÷ 27.4).  Phyllis should take out at least that amount by no later than April 1, 2003.

In 2003, Phyllis must take her second required distribution by December 31, 2003, (meaning if she waits until 2003 to take her first distribution, she'll have two distributions bunched in one year and possibly a higher tax bracket for 2003). The second distribution will equal her December 31 account balance from the end of this year divided by her life expectancy divisor, based on her age at the end of 2003.

Although the new rules have generally decreased the amount that's required to be distributed annually, an account owner is always free to take a larger distribution if desired.

BENEFICIARY DESIGNATION

With one exception, the new distribution rules automatically assume the account owner has designated a person who is 10 years younger as the sole account beneficiary. (The exception applies when the sole beneficiary of the account is the owner's spouse and he or she is more than l0 years younger than the owner.) As a result, it normally doesn't matter who the beneficiary is for the purpose of determining the required distributions while the account owner is alive. However, the new rules make it clear that it is still critically important to name a beneficiary (and contingent beneficiary) before the account owner's death. Failing to do this can significantly impact the required annual distributions from the IRA after the owner's death.