Tax and Business Alert - September 2003

Tax Planning for Mutual Funds

More good news from recently passed tax legislation! With some restrictions, dividends received from regulated investment companies (i.e., mutual funds) are eligible for the new lower capital gains tax rates approved in the Jobs and Growth Tax Relief Reconciliation Act of 2003. Essentially, qualifying dividends received in all of 2003 will be taxed at the lower capital gains rates 15% (0% in 2008), for lower tax bracket taxpayers, or 15% and not the higher personal tax rates (up to 35% in 2003). However, what normally is paid out by mutual funds as dividends is made up of different types of income, i.e., interest, short-term capital gains, and dividends received from various stock investments held by the fund. Only the actual dividends received from the stock investments held by the fund and included in the fund's distributions will be eligible for the new lower tax rates. The interest income and short-term capital gains will presumably be shown on Form 1099 as dividends ineligible for the new lower capital gains rates.

The possibility of a lower tax rate on dividend income may cause you to consider adjusting the type of mutual funds held within your taxable investment accounts. Selecting mutual funds with more dividend paying stocks could lead to an increase in the after-tax return on your mutual fund investments. You should keep in mind that, generally, dividends received from mutual funds in tax-deferred investment accounts [i.e., 401 (k) and traditional IRA] are eventually taxed at the higher personal tax rates when withdrawn from these accounts.

If you elect to reinvest your mutual fund distributions and thereby purchase more fund shares, your tax basis for computing gain or loss generally increases with every reinvested distribution. When you sell or redeem your mutual fund shares, it's critical that you include the entire basis amount (the cost of all shares) when computing your gain or loss. If you don't include your reinvested distributions, you're paying double tax because you were already taxed when you originally received those distributions. Keeping track of your mutual fund's cost basis can be even more complicated because the additional shares purchased with each reinvested dividend have their own holding period for determining capital gains treatment.

When you sell or redeem mutual fund shares without liquidating your entire investment, you have several options for determining how much basis (cost) is assigned to the shares you sold. If you purchased shares on different dates and at different prices, the method used to determine your cost basis can significantly affect both the amount of gain or loss and the holding period. Contact us to discuss the options available for recognizing a mutual fund's cost basis.

Another planning issue relates to choosing specific mutual funds for your taxable accounts. If possible, choose funds that meet your investment goals and that are also tax efficient. Generally, tax efficiency is a function of portfolio turnover (the level of a mutual fund's selling activity). High levels of sales activity generally result in higher realized capital gains. Funds that invest for the long-term tend to generate fewer realized capital gains. With these funds (invested for a longer term), you realize most of your appreciation when you sell your fund shares. Although you cannot control the fund's timing of investment sales (and, therefore, capital gain recognition), you can choose funds that are tax efficient or index funds that are not actively managed.

IRS Update

Obtain Employer ID Numbers Online: Businesses can obtain employer identification numbers (EINs) directly from the IRS at www, irs.gov after submitting an online application. This EIN will be permanent unless the IRS determines it issued another EIN to the business, or that the name and social security number of the company's principal officer do not match social security records. However, the online application process is not available to some EIN requestors including government agencies and taxpayers with addresses outside the 50 States.

Business Retirement Plan Deadline: Businesses using "off-the-shelf" retirement plan documents (such as Master & Prototype plans from banks, brokers, insurance companies, lawyers, and consultants and Volume Submitter plans obtained from lawyers and consultants) must update their plans by September 30, 2003. Businesses must formally adopt plan updates to maintain the tax benefits associated with their retirement plans. Although the sponsors may have updated the plan documents, employers still need to formally adopt the updated plans by September 3Oth to maintain the plan's tax-favored status.

Interesting Investment Website for Dividend Information

Under the Jobs and Growth Tax Relief Reconciliation Act of 2003, dividends received by an individual (noncorporate) shareholder from domestic and qualified foreign corporations generally are taxed at the same rates that apply to long-term capital gains (15% maximum). Dividends were previously taxed at the higher personal tax rates (35% maximum in 2003). This treatment applies for both regular and alternative minimum tax purposes. The new lower tax rate (effective for all of 2003) should significantly increase the level of investor interest in dividend (income) paying stocks.

Quantum Online at www.quantumonline.com provides online information on income producing investments such as preferred stocks and a variety of other income investment possibilities that would be of interest to investors. Quantum's Stock Lists page provides links to key sources of investment information on securities in a particular category that are listed on the major stock exchanges. There are tables for preferred stocks, trust preferred stocks, convertible securities, exchange traded debt securities, and asset backed income securities. There are also lists for real estate investment trusts, special investment products, closed-end mutual funds, exchange traded-funds, master limited partnerships, and royalty trusts.

Each table provides the basic information on each security such as Moody's and S&P credit ratings, IPO date, liquidation preference, redemption price, redemption date, maturity date, coupon rate, and the distribution dates. For each security, the table also offers a link to the current quote on the appropriate stock exchange, a link to a chart of the historical prices of the security, a link to the IPO prospectus for the security on the SEC EDGAR system and a link to the Yahoo detailed quote on the security, which offers the latest dividend payout information.

The Quantum Online Information Page gives you a detailed description of the security, links to the company's online information, contact information including email addresses and phone numbers, a link to the parent company's information, plus a variety of links to additional information on the company or security.

Increased Depreciation Limits for Business Vehicles

The IRS recently issued guidance to exclude certain trucks and vans from the annual depreciation expense limitations on luxury automobiles meant to discourage overspending on passenger cars used for business. The new rules exclude any truck or van that is a qualified non-personal use vehicle from the luxury automobile limitation. The exclusion will apply to qualified moving vans, delivery trucks, utility repair trucks, or any specially modified vehicle that is unlikely to be used more than a de minimis amount for personal purposes. The rules, effective for property placed in service after July 6, 2003, were issued in response to business owners' concerns that they could not fully depreciate certain vans and light trucks in five years as allowed for business use vehicles not subject to the luxury automobile limitation.

Adoption Credit and Income Exclusion Provide Financial Assistance

You can claim a tax credit for certain eligible adoption expenses and generally exclude from income employer-provided adoption assistance. The credit and employer exclusion are subject to specific dollar limitations and phase-outs when your income exceeds certain thresholds.

Adoption Credit

The $10,160 limitation is not an annual limitation; instead, it applies to the adoption of each eligible child and is cumulative for that child over all tax years. The limitation is the same for both married and unmarried taxpayers. However, married couples must file a joint return to claim the credit.

Eligible Child: An eligible child is any individual who is (a) under the age of 18 at the time of the adoption or (b) physically or mentally incapable of caring for himself or herself. An eligible child with special needs is one who meets additional specific requirements including U.S. citizenship or residency status.

Eligible Expenses: Adoption expenses eligible for the credit include any reasonable and necessary expenses, including adoption fees, court costs, attorney fees, and travel expenses paid in relation to the legal adoption of an eligible child. Adoption expenses incurred for the adoption of a spouse's child or reimbursed under an employer program (see below) do not qualify for the credit.

Claiming the Credit: When adopting an eligible child who is a citizen or resident of the U.S. (a domestic adoption), the credit is allowed in the tax year following the year the expenses are paid. If the adoption expenses are paid in or after the tax year the adoption becomes final, the credit is allowed in the tax year the expenses are actually paid. Adoption expenses relating to a child who is a citizen or resident of the U.S. are eligible for the credit, even if the adoption is never finalized.

The $10,160 automatic credit, without regard to actual expenditures, for adopting a special needs child is only available in the year the adoption is finalized. However, a credit for actual expenses incurred (up to $ 10,160) can be claimed for years before the adoption is finalized in a manner similar to a domestic adoption without special needs. A credit for only the actual expenses incurred up to $10,1 160 can be claimed for a failed special-needs adoption. A domestic adoption is generally considered final when the state of the child's residency considers the child legally adopted.

Adoption expenses relating to a noncitizen, nonresident child qualify for the credit only if the adoption is finalized, and the credit is available only in the year the adoption becomes final. Adoption expenses paid in any year prior to the year the adoption is final are treated as paid in that tax year (the year the adoption is final). A foreign adoption is considered final in accordance with the laws of the country of the child's citizenship.

Phase-out: For 2003, the adoption credit begins to phase out when your modified adjusted gross income (MAGI) exceeds $152,390 and is completely phased out when your MAGI is $192,390. The phase-out is the same for each filing status except married filing separate, in which case a credit generally cannot be claimed.

Income Exclusion

You can exclude from income up to $10,160 of adoption expenses paid by your employer under the employer's adoption assistance program. However, unlike the credit, employer adoption assistance payments made for a domestic adoption are excludable from income in the year the payments are made (no one-year delay rule exists). For foreign adoptions, as with the credit, the exclusion is available only in the year the adoption becomes final.

You can claim both a credit and an exclusion in connection with the adoption of an eligible child. However, the same adoption expenses cannot be considered for both.

Setting Investment Goals

Establishing investment goals is an important step in developing your financial plan. In one sense, goal setting is a separate and distinct step in the investment planning process. In another sense, goal setting is a fluid part of the process since goals themselves, or the relative priorities of some goals, may change. During the goal setting process, you should identify and quantify your investment goals and develop a reasonable time frame for reaching each of them.

Developing an investment plan to meet your investment goals should help you to recognize your investment preferences, determine your level of sophistication as an investor, and recognize and deal with your investment fears. You should educate yourself regarding risk/reward relationships, investment philosophies, procedures, and style. An investment plan based on needs, goals, objectives, and the related constraints becomes the roadmap for reaching your investment goals and for dealing with future developments and opportunities.

The first step in identifying and defining goals is to state them broadly, i.e., needing funds for education, retirement, liquidity, or wealth accumulation. Next, specifically define goals in terms of the type of return required such as current income, tax-exempt income, or capital appreciation.

Each stated goal should be quantifiable and measurable. For example, funds invested to provide $35,000 in three years to purchase a car. Your goals should then be prioritized because we typically want more than we can afford, and taking more risk to enhance investment returns could subject you to more portfolio volatility than you would want.

Writing goals will help you focus on what you honestly hope to achieve and, to some extent, consider the reasonableness of those goals. Prioritizing goals is critical when not all goals can be achieved within the stipulated time horizon and with available resources.

Each goal should have a stated time horizon, i.e., how long will it be before the invested funds are needed for a given purpose and how long the need will last (e.g., retirement for 30 years). Time horizons tell you when you will need the money and the period of time you will depend on selected assets to generate the necessary cash flow. They also give you dates to work toward and are critical factors in determining the appropriate asset allocation.

It is critical not to underestimate your investment time horizons. For example, if you are planning to retire in ten years, you may think of switching to a fixed income portfolio at retirement. By doing so, you have ignored the fact that your time horizon is really until death and you will need your money to continue growing to compensate for the loss of purchasing power.

Many investors express goals in terms of tax planning concerns. The relationship of investment and income tax planning must be considered because taxes can have a significant effect on rates of return. Some investment vehicles can help you defer or eliminate income taxes (mutual funds have special tax considerations). However, tax considerations should generally take a back seat to investment issues. In a given situation, you may not be able to avoid a taxable transaction even if you prudently manage your investment portfolio.