Tax and Business Alert - March 2004

The New Health Savings Account

The President recently signed legislation authorizing Health Savings Accounts (HSAs), which are targeted mainly at self-employees, small business owners, and employees of small to medium size firms. It is important to understand that, while this new tax break was included in the recent Medicare Act, you don't have to be a senior citizen to benefit.

Starting in 2004, eligible individuals can use HSAs to cut their federal income tax bills. Better yet, HSAs should be as easy to set up as IRAs. HSAs will be available to high earners and low earners alike; there are no phase-out rules to limit the benefits for the high-income folks. In addition, employers can fund HSAs for their eligible workers with the contributions treated as a tax-free fringe benefit. This aspect of HSAs should be particularly appealing to closely held business owners.

Now for the ground rules, HSAs are only available to individuals covered by health insurance with relatively high annual deductibles. By that, we mean at least $1,000 for single coverage or $2,000 for family coverage. Many self-employed small business owners and employees of small to medium size companies fit this description.

For 2004, eligible individuals can make deductible HSA contributions limited to the lesser of:

1. The insurance deductible amount, which must be $1,000 or more for self-only coverage or $2,000 or more for family coverage, or
2. $2,600 for single coverage or $5,150 for family coverage.

For 2005 and beyond, these figures will be adjusted for inflation.

The deduction for HSA contributions is claimed above the line in arriving at adjusted gross income (AGI). So, eligible individuals can benefit whether they itemize or not. However, the deduction won't reduce a self-employed person's self-employment (SE) tax bill.

The HSA beneficiary can take federal-income-tax-free withdrawals to pay uninsured medical expenses for the account beneficiary, spouse, and dependents. However, tax-free withdrawals cannot be taken to pay premiums for the high deductible health coverage itself. Withdrawals not used to pay uninsured medical expenses are taxable and are generally subject to a 10% penalty before age 65. There is no 10% penalty after the account holder becomes disabled or dies.

Placing a conservation easement on land you own means that a permanent restriction on its use or development is granted to a qualified charitable organization, often without impacting your current use or enjoyment of the property. The easement provides an opportunity to preserve your land for future generations and generate substantial income and estate tax benefits for you.

For lifetime contributions, you are entitled to an income tax deduction equal to the fair market value (FMV) of the qualifying easement. If you own the property at your date of death, it is included in your gross estate at its post-easement value, effectively reducing your property's estate tax value by the amount of the easement. In addition, the value of the property net of the easement is eligible for an estate tax exclusion of up to $500,000.

For a conservation easement created at the time of your death, an estate tax deduction is allowed for the value of the easement, and the land subject to the easement is eligible for an estate O tax exclusion of up to $500,000.

IRS Urges Caution When Making Vehicle Donations

Of the 129 million individual tax returns filed for tax year 2000, the General
Accounting Office (GAO) estimates 733,000 returns had a tax deduction for a vehicle donation. These donations were valued at about $2.5 billion, reducing taxpayer liability by an estimated $654 million.

The IRS recently issued a consumer alert recommending persons considering donating a vehicle to a charity first determine that the charity is a qualified organization. Otherwise the donation will not be tax deductible. Taxpayers can determine if a charity is qualified using the IRS website at www.irs.gov. Refer to Publication 78.

Publication 78 is an annual, cumulative list of most organizations that are qualified to receive deductible contributions. Be sure to have the organization's correct name and its headquarters location, if possible. Note that churches, synagogues, temples, mosques, and governments are not required to apply for this exemption in order to be qualified. They frequently are not listed in Publication 78. Donations to these organizations are tax deductible.

One Stop Reference Website

How much time would you save on computer searches if you didn't have to drill through several layers to get to the specific link you wanted? Refdesk.com provides a well-organized and family-friendly source for direct links to current information-based sites. As expected, there are links to phone number locators, current headlines, market quotes, weather data, search engines, games, etc. In addition, you can click to such diverse sites as Kelly's Blue Book, Letterman's top 10 lists, currency converters, postage rates, crosswords, comic strips, government agencies, homework helpers, genealogy info, dictionaries, several encyclopedias, dozens of magazines, and hundreds of newspapers. Be aware, however, that the time you'll save by using www.refdesk.com may now be spent exploring all it offers. After all, who can resist checking out the CIA World Fact Book?

Retirement Plan Distributions Made Before Age 59 ½

You probably know that qualified retirement plan or IRA distributions before you reach
age 59 ½ are subject to a 10% penalty tax in addition to any applicable income tax. This rule is to encourage savings for retirement, which is clearly a sound financial objective. But, sometimes financial circumstances make it necessary to withdraw retirement plan savings before age 59 ½ . If you must make an early withdrawal, there are some ways to avoid the 10% penalty. Also, if available, a qualified retirement plan loan can be structured as a nontaxable event, which would let you avoid a plan withdrawal and the 10% penalty tax.

Qualified Plan Distributions for Participants Age 55 or Older
A fairly narrow exception to the 10% penalty tax applies if you participate in a qualified retirement plan sponsored by your employer. If you are at least age 55 and terminate your employment, plan distributions are not subject to the penalty tax. The key is that you must both terminate employment and receive the distribution during the same year after reaching age 55 and before age 591A unless another exception applies. Surprisingly, the exception continues to apply even if you later go back to work for the same or a different employer. This exception can be used to plan for early retirement.

Substantially Equal Periodic Payments
A broader exception is available for qualified retirement plan participants and IRA owners. Regardless of your age, a series of "substantially equal" payments is not subject to the 10% penalty tax. However, distributions from a qualified retirement plan (not IRAs) are excepted only if you no longer work for that employer. The payment amount is determined by your life expectancy (i.e., is computed to deplete your account if you live to your anticipated life expectancy). However, the payments do not have to actually continue for your entire life. Instead, they can stop at the later of the date (1) you reach age 591A or (2) five years have elapsed. There are several methods for computing the payments, so it is possible to tailor payments to fit your financial needs.

Deductible Medical Expenses
Qualified retirement plan and IRA distributions up to the amount of your deductible medical expenses are not subject to the 10% penalty tax. This exception may be somewhat limited, however, since deductible medical expenses are only those over 7.5% of adjusted gross income. If your deductible medical expenses exceed that threshold, a penalty-free distribution can be made even if you don't itemize deductions.

Qualified Education Expenses
IRA (but not qualified retirement plan) distributions can also be made without incurring the 10% penalty tax if they are used for qualified education expenses, which include tuition, fees, books, supplies, or required equipment for college (or certain postsecondary vocational schools). Expenses for room and board also qualify, up to a certain amount. The taxpayer, his or her spouse, children, stepchildren, or grandchildren can incur the expenses.

First-time Homebuyer Expenses
Finally, you can withdraw up to $10,000 from an IRA (but not a qualified retirement plan) for first time homebuyer expenses without incurring the 10% penalty tax. The distribution must be used to buy or build a principal residence for you or certain family members if the purchaser has not owned a home for at least two years. Reasonable settlement, financing, or other closing costs (i.e., points) are qualifying expenses.

Save Taxes When Extracting S Corporation Cash

As a shareholder, you may be receiving several types of payments from your
S corporation, including a salary, rental payments from real estate you lease to the corporation, and a portion of the S corporation's net income. While both salaries and rents paid by the S corporation must be reasonable in relation to the value of services or property provided, there is inevitably some degree of flexibility about the actual amount of any of these payments. Since even minor fluctuations in these payment categories can produce differing tax results, you may want to consider the following ideas for saving taxes when extracting S corporation cash.

Income Shifting
S corporation shareholders often attempt to minimize their compensation to increase the pass-through income flowing to other owners (typically children in a lower tax bracket). Clearly, an owner rendering significant services to the corporation cannot unreasonably reduce his or her salary to increase income to other shareholders. However, reasonable adjustments may be made with this objective in mind. Reasonable compensation should be determined based on the shareholder's qualifications and duties, the relationship of the shareholder's compensation to that of all the corporation's employees, salaries paid by comparable companies, and the relationship between compensation and shareholder return on investment.

Reducing Compensation
Wages paid to an S corporation shareholder-employee are subject to payroll taxes. However, pass-through S corporation income is not. Thus, shareholder employees may be able to reduce their payroll tax liability by minimizing salaries to receive additional pass-through income.

The IRS is aware of this strategy and has successfully fought it where shareholder compensation was obviously less than reasonable. Despite these IRS victories, an S corporation shareholder's salary may be established at the lower end of a reasonable range, especially when services are not the primary income-producing activity of the corporation.

Generating Rental Income
It is generally beneficial for an owner to rent real estate to the S corporation because any resulting net rental income is exempt from payroll taxes. But the arrangement must be reasonable because the IRS has ample authority to recharacterize rent payments as compensation or dividends to the extent they exceed market rates.