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August 2002

Mid-Year Planning

Effective tax and financial planning requires ongoing attention to your business and personal financial affairs. At the same time, changing tax rules provide new tax saving opportunities in addition to the traditional planning techniques. If you haven't already considered planning strategies for 2002, now is a good time to begin. Below we've listed a few tax-saving ideas to get you started in the planning process.

* It might be time to review you stock and bond portfolios to see if any rebalancing or changes are needed. When selling securities in taxable accounts, however, it pays to remember certain tax rules. First, long-term capital gains are taxed more favorably than short-term gains so whenever possible, delay the sale of a profitable security until you have held it more than one year. On the flip side, capital losses can offset your capital gains plus up to $3,000 ($1,500 if married filing separately) of your ordinary income so dumping your losing securities can pay off. But whenever you sell securities at a loss, don't forget the wash sale rules that essentially nullify your loss if you purchase substantially identical stock or securities within the period beginning 30 days before and ending 30 days after the sale date.

* Saving for college has vastly improved with recent changes to Coverdell Education Savings Accounts (ESAs), formerly called Education IRAs, and state-sponsored Section 529 plans. Although no federal income tax deduction is allowed when you contribute to these accounts, the earnings in the accounts will never be taxed if the funds are ultimately used for qualified education expenses. For ESAs, qualified expenses now include both college-related costs and K-12th grade costs. Depending on your particular needs, one saving vehicle might be more advantageous than the other.

* Employing your children in a family business, particularly sole proprietorships, can have tax advantages. In addition, children with earned income are eligible to contribute to Roth IRAs. Making Roth IRA contributions while a teen, even if relatively small, can grow to a very significant tax-free amount by retirement.

* The 2002 Tax Act gives businesses additional incentive to purchase new business assets this year. Most new assets are now eligible for a special first-year "bonus" deprecation deduction equal to 30% of the asset's cost. This is in addition to normal first-year depreciation on the remaining cost basis and the Section 179 deduction, if available. Greater deductions are also available for new so-called luxury autos placed in service in 2002.

* If you work for someone else, but also have a sideline or part-time business, consider setting up a SEP-IRA or SIMPLE-IRA retirement plan to shelter part of your business income from current tax. New retirement plan rules make these more attractive than ever.

* And finally, don't overlook the alternative minimum tax (AMT) when planning for 2002 and beyond. The AMT now impacts many unsuspecting middle-income and upper middle-income taxpayers in addition to the higher-income taxpayers originally targeted for the tax.

The income taxes you pay don't result from a single transaction you made during the year, but from the many business and investment decisions you make throughout the year. Therefore, it only makes sense that if you want to minimize your taxes, you need to plan as the year goes along and not just at year-end. This way you'll be ready to take advantage of tax saving opportunities as they arrive and ensure that your business and investment transactions are done in the most tax-efficient manner possible.

Tax planning is particularly important in our current environmen because the tax rules are changing. While the tax-saving opportunities of the 2001 Tax Act received much publicity when it was enacted, the Act's true impact will be felt over a number of years. That's because many of the rules phase in over a period of time and some come and go during the next several years. Not only that, but Congress slipped in a 2002 Tax Act earlier this year. This second Act contains several tax saving opportunities, particularly for businesses. With all this activity, it's easy to see why it's so important to stay on top of all the changes.

In this letter we've focused on tax and financial planning strategies you should consider now and through the rest of the year. Some are the result of the 2001 and 2002 Tax Acts while others are traditional tax-saving techniques. Contact us if you have any questions about which of the ideas might be appropriate for your particular situation or if you want to discuss other tax saving strategies. And remember, the sooner you start planning, the more chances you'll have to reduce your tax load for 2002 and beyond.

Let's Begin with Your Investments . . .

Securities Transactions. It's always a good idea to periodically check your stock and bond portfolios to see if your investment allocations need rebalancing and to identify gains to recognize or losers whose time is up. Before making any changes, however, be sure to consider the tax ramifications. While the tax consequences should normally not drive your decisions, they can impact when you act or the securities you choose to sell. For example, selling appreciated securities you've held for more than a year will generally cost you no more than 20% in federal income taxes, while locking in those gains by selling before that time can cost you almost twice as much in taxes.

Like timing, selecting specific shares to sell can make a big tax difference. Generally when you sell stock and mutual fund shares, the shares you purchased first are deemed sold first. This is definitely not to your advantage if you have newer shares with a higher basis (for example, because you paid more for them). Fortunately, if you properly notify your broker as to the specific shares you want sold, those identified shares are treated as sold instead. This means that given the right circumstances, reducing a tax gain (or increasing a tax loss) can be as simple as selecting shares with a higher tax basis.

It may also be a good idea to consider selling some of your losing stocks. In addition to reducing any capital gains you've realized, capital losses can offset up to $3,000 ($1,500 for married filing separate returns) of your ordinary income each year. Furthermore, it often makes sense to recognize a loss sooner rather than later. This is because short-term capital losses can be more valuable than long-term losses when you have long-term and short-term gains and the loss offsets otherwise taxable short-term gains. But when dealing with losses, don't forget the wash sale rules. Purchasing substantially identical stock or securities within the period beginning 30 days before and ending 30 days after the sale will nullify the loss.

Like-kind Exchanges of Real Property. Thinking about selling investment real estate and investing in more real estate or converting raw land to income-producing property? An often overlooked but potentially significant tax saving strategy is the like-kind exchange. In a like-kind exchange, you exchange your investment real estate for another investment property and in so doing, you defer gain on your property. And if certain conditions are met, the exchange of properties need not be simultaneous and it can involve multiple properties. To qualify as a tax deferred like-kind exchange, certain requirements must be met and you generally recognize some gain if you receive cash as part of the deal. Nevertheless, a like-kind exchange can be a particularly valuable tax planning technique when real estate investments are involved.

What about Education Expenses?

Do you have children or grandchildren with college in their future? If so, a number of tax and financial planning strategies should be considered when saving or paying for college costs. Proper planning normally includes a complete look at the available tax incentives, considering the ages of your children or grandchildren plus the impact of possible financial aid. Let's look at a few of the key strategies.

Savings Accounts. The Coverdell Education Savings Account (ESA) and state-sponsored Section 529 plans are particularly attractive tax advantaged ways to save for college, especially after the changes made by the 2001 Tax Act. While neither provides a federal tax deduction for contributions, the earnings in the accounts are tax-free to the extent the funds are used for qualified education expenses.

With the revamped ESAs (formerly called Education IRAs), funds in the account can now be used for K-12th grade expenses, including a family's home computer, in addition to higher education costs. Beginning in 2002, up to $2,000 can be contributed to each child's ESA each year. Funds in Section 529 plans, on the other hand, can only be used for college costs but the annual contribution limits, which are determined by each particular state plan, are generally much higher. Many states allow a state income tax deduction for residents who contribute to their own state 529 plan so it's typically best to look first to your own state plan when considering 529 plans. However, you can generally choose to invest in any state's plan and the funds can normally be used at any college or university in the country.

Like saving for retirement, saving for college costs is time-sensitive. Therefore, the sooner you begin taking advantage of a college savings vehicle, the more likely you'll be to meet your college savings goals. Now might be a good time to consider an ESA or 529 plan, or both, for your family's future education costs

College Tuition Deduction. Beginning in 2002, joint filers with adjusted gross income (AGI) of $130,000 ($65,000 for singles and heads of households) or less can claim a deduction of up to $3,000 for qualified college tuition and related expenses, without regard to whether they itemize deductions. This above-the-line tax deduction is short-lived, however, since it is only available through 2005. In 2004 and 2005, the allowable deduction amount is increased and the AGI thresholds increase. But pay particular attention to the relevant AGI level. Unlike many other tax deductions or credits that gradually phase out over a range of AGI, this tuition deduction is all or nothing depending on whether your AGI is below or above the threshold amount. Thus, if you pay tuition expenses in 2002 and your AGI is around the $130,000 (or $65,000) limit, planning to ensure your AGI remains at or below the threshold can become particularly important.

Financial Aid. Planning for college costs should also include an analysis of a family's financial aid prospects because strategies that might be effective from a tax standpoint can sometimes backfire when they negatively impact the amount of financial aid a family receives. For example, under the financial aid guidelines, assets owned and income generated by the parents are assessed at lower rates than the assets and income of the student. Thus, financial aid considerations can impact which college savings vehicles you choose or the strategies you employ to pay current college costs. Your family's financial situation plus the number of current or future college students in the family and their current ages are all important factors to consider when planning.

Planning for Your Business

Employ Your Teenagers. If you are self-employed, employing your children (or grandchildren) can lower your family's overall tax bill. By paying your child wages, you effectively shift income from a higher bracket taxpayer (you) to a lower bracket one (your child). And because the income is considered earned income to your child (as opposed to unearned income like dividends and interest), it can be offset by his or her standard deduction ($4,700 for 2002). To the extent the income is taxed, a low 10% rate will generally apply to all or part of it. Thus, the family's income tax savings can be significant since some of the income normally taxed at your rate might escape taxes entirely or be taxed at your child's low rate.

There can also be payroll tax savings when employing your child. Wages paid to a child under the age of 18 from a parent's sole proprietorship are exempt from social security and unemployment taxes. Thus, depending on your total self-employment earnings, your tax savings can also include up to an additional 15.3% of the amount of wages you pay to your child since you avoid paying self-employment tax on that amount and no payroll taxes are due on the wages.

Employing your teenager has the side benefit of enabling him or her to make an IRA contribution. With earned income (received from your business or elsewhere), your child is eligible to make a 2002 contribution to a traditional or Roth IRA, up to the lesser of $3,000 or earned income. Generally, the Roth IRA is the better choice because although no deduction is allowed for the contribution, the earnings will never be taxed if your child does not withdraw them until at least age 591⁄2. That's a long time for the funds to grow. And if you choose, you
can gift your child the funds to make the allowable contribution.

Before leaving this subject, it's important to point out two things. First, you must make sure that any wages you pay your child are reasonable based on the work performed and the child's age. Second, if your child is in college or is going to college soon, shifting income to him or her can have a detrimental impact on your family's eligibility for need-based financial aid because, as mentioned earlier, your child's income and assets are assessed at higher rates than your own when computing a family's financial aid eligibility.

New Assets. With the hope that better economic days are around the corner, many businesses are looking for ways to cut their upcoming tax liabilities. Thanks to the 2002 Tax Act Congress snuck in this past March, businesses now get additional tax write-offs when they purchase new assets. Under the new rules, you can claim an additional "bonus" depreciation deduction of 30% of the cost of most new business assets acquired this year. That's 30% of the cost of the assets right off the top! Regular depreciation and, if eligible, the Section 179 deduction can also be claimed for the property. The 2002 Act also loosened the so-called luxury auto depreciation limits. Thus, higher first-year depreciation deductions are available for new autos you place in service in 2002.

To see just how significant this tax break can be, check out this example. Assume a business acquires $100,000 of new seven-year property and is also eligible to claim the Section 179 deduction. The Section 179 deduction of $24,000 is claimed first. Of the remaining $76,000 of costs, $22,800 is deducted as 30% bonus depreciation followed by regular first-year depreciation of $7,602 on the balance of costs (i.e., $53,200). That's a whooping $54,402 of total first-year deductions. So if you've been holding off buying new business property, now might be a good time to make the purchase.

Retirement Plans. If your business doesn't offer a retirement plan, now might be the time to take the plunge. New retirement plan rules allow for higher deductible contributions. Even if your business is only part-time or something you do on the side, contributing to a SEP-IRA or SIMPLE-IRA can enable you to reduce your current tax load while
increasing your retirement savings. With a SEP-IRA, you generally can contribute up to 20% of your self-employment earnings, with a maximum contribution of $40,000. A SIMPLE-IRA, on the other hand, allows you to
set aside up to $7,000 plus an employer match that could potentially be the same amount. In addition, if you're age 50 or older by year-end, you can contribute an additional $500 to a SIMPLE-IRA.

Beginning in 2002, certain small employers that start a retirement plan can claim a tax credit of up to $500 for the administrative and retirement-education expenses of adopting a new retirement plan for employees. The allowable credit is equal to 50% of the first $1,000 of eligible expenses. However, it does not appear the credit is allowed when a plan only covers a self-employed individual.

Alternative Minimum Tax Planning Any planning for the rest of this year and beyond should include a thorough assessment of your exposure to the alternative minimum tax (AMT). Although the AMT was originally designed to limit the ability of higher-income individuals to benefit too much from certain tax loopholes, it now also impacts many unsuspecting middle-income and upper middle-income taxpayers. The AMT puts a completely different spin on tax planning strategies. Some that make sense in a non-AMT situation are not beneficial when AMT applies. We can help you plan for, and possibly reduce or eliminate, an AMT liability.

Review Your Estate and Financial Planning Documents.

There is no better time than the present to review your various estate and financial planning documents.

* Wills. Now is a good time to review your will to ensure it's up to date with the changing estate tax rules and any changes in your personal life. The 2001 Tax Act increase to the allowable estate tax exclusion was great news. However, it can cause havoc for many estate plans based on wills not written with the increase in mind. In addition, it's a good time to review your designated executor and any guardians or trustees.

* Powers of Attorney (POAs). It's important to periodically review your POAs to ensure the individuals or other parties identified are the ones you still want for these duties (and that they're willing). This would include your durable POA, your health care POA, and your Directive to Physicians. It's also important that you consider whether you want to specifically include the power to make gifts in your POA since the IRS normally requires this specific power before it recognizes gifts made on your behalf by your designee.

* Beneficiary Designations. Are the beneficiary designations on your retirement accounts and life insurance policies current? Failing to update beneficiaries in response to changes in your personal life can have a disastrous impact in the future. And don't forget to keep a copy. That way there is no misunderstanding as to the identity of your beneficiary.

These are just a few of the documents that you probably need to review. Others might include buy/sell agreements related to any closely-held business interests you own, titling of jointly owned accounts, testamentary letters, and revocable living trust provisions (and the status of funding the trust).

Conclusion

This letter highlights selected tax and financial planning strategies you might consider but, based on your particular situation, there are likely many others as well. Through careful planning and periodic review, you can keep your tax and financial situations in tip-top shape. We are available to assist you in this effort in any way we can. Please don't hesitate to call us with questions this letter might have raised or so we can discuss additional planning strategies.

Very Truly Yours,

CPA Advisory Group, Inc.

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