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November 2002

Year End Tax Planning

It's hard to believe that 2002 is winding down and, like past years, it's time to consider year-end tax planning. In so doing, it's important to remember that while there are many traditional year-end planning strategies, each year offers new ones as well, due to changes in your own tax and financial situation, as well as changes to the tax rules. And 2002 is certainly no exceptions as far as the rules go. In March 2002, Congress passed the Job Creation and Worker Assistance Act of 2002. This, combined with the phase-in of many of the tax changes from the 2001 Tax Act, presents new tax saving opportunities for 2002.

Effective year-end tax planning typically means looking at your tax situation over a two-year period-the current year (2002) and next year (2003). This enables you to see whether it's advantageous, for example, to shift income and deductions from one year to the other or whether the dreaded alternative minimum tax (AMT) is a factor to consider. But, regardless of the extent of your year-end planning process, it's likely that you can benefit from one or more of the tax saving strategies highlighted in this letter. So, with this in mind, let's take a look at some of the strategies that might help you keep more of your hard-earned money in your pocket instead of Uncle Sam's.

Look First at the Possibility of AMT

The first step in year-end planning is to see whether you might be subject to AMT this year (or next year for that matter). Taxpayers must compute their taxes under both the regular tax and AMT rules and then pay the greater of the two. Although AMT was originally designed to apply only to taxpayers who took too much advantage of certain tax breaks, the current rules encompass many unsuspecting taxpayers. Being in the world of AMT puts a whole new spin on tax planning because many great planning strategies that make sense in a regular tax situation completely backfire in AMT.

Certain items can increase your risk of AMT, including exercising incentive stock options, substantial long-term capital gains, and a significant amount of miscellaneous itemized deductions. But no one is safe from AMT anymore, and planning when AMT applies is tricky because each situation is unique. Therefore, if you have any of the items mentioned or suspect AMT might be an issue, please contact us so we can help you review and plan for your particular situation. Now that we've addressed the AMT matter, let's move on to a variety of tax planning strategies that normally apply to the vast majority of taxpayers-that is, those in a regular tax situation.

Deferring Income and Accelerating Deductions

The most common year-end tax planning strategies are those that defer income from the current year to later years and those that move deductions from later years into the current year. The underlying reason is that it's better to pay taxes later rather than sooner due to the time value of money. This concept is even more relevant now since tax rates are scheduled to go down in the future. Rates are the same for 2002 and 2003, but they decline 1% in 2004 and again in 2006. Thus, shifting taxes from 2002 to later years not only benefits from the time value of money, but you might also pay less due to lower future rates.

So, how do you shift income and deductions between tax years? The most common techniques are using income or deductions that you can easily control. For example, if you're due a year-end bonus and you can get your employer to agree, receive the bonus in January 2003 rather than 2002. For sales of property, consider an installment sale that shifts part of the gain to later years when the installment payments are received. On the deduction side, move charitable donations you would normally make in early 2003 to the end of 2002. Do the same with real estate taxes or state income taxes. If you own a cash-basis business, delay billings so payments aren't received until 2003 or accelerate paying of certain expenses, such as office supplies and repairs and maintenance, to 2002. Of course, before deferring income, you must assess the risk of doing so.

Managing Your Adjusted Gross Income (AGI)

Many tax deductions and credits are subject to AGI-based phase-out, which means only taxpayers with AGI below certain levels benefit. [AGI is the amount at the bottom of page 1 of your Form 1040-basically your gross income less certain adjustments (i.e., deductions), but before itemized deductions and the deduction for personal exemptions.] Unfortunately, however, the applicable AGI amounts differ depending on the particular deduction or credit. The following table shows a few of the more common deductions and credits and the applicable AGI phase-out ranges for 2002:

Knowing and, to the extent possible, managing your AGI can be the difference between claiming all or part of a deduction or credit, or none of it. Therefore, being aware of the deductions and credits you are eligible for, but which are subject to AGI limits, can help you plan to ensure you can claim them. Managing your AGI can be somewhat difficult, though since it is not affected by many deductions you can control, such as deductions for charitable contributions and real estate and state income taxes. However, to the extent you can claim additional "above-the-line" deductions, such as those for IRA or self-employed retirement plan contributions, or reduce or shift taxable income to a later year, you can effectively reduce your AGI and, in turn, claim more deductions or credits that might otherwise phase-out.

Strategies Involving Your Securities

Claim Capital Losses. There are a number of year-end investment-related strategies that can help lower your tax bill. Perhaps the simplest is reviewing your securities portfolio for any losers that can be sold before year-end to offset gains you have already recognized this year or to get you to the $3,000 ($1,500 married filing separate) net capital loss that's deductible each year. Don't worry if your net loss for the year exceeds $3,000, because the excess carries over indefinitely to future tax years. Be mindful, however, of the wash sale rule when you jettison losers. Under this rule, your loss is deferred if you purchase substantially identical stock or securities within the period beginning 30 days before and ending 30 days after the date of sale.

Be Choosy When Selling Securities. When selling stock or mutual fund shares, the general rule is that the shares you acquired first are the ones you sell first. However, if you choose, you can specifically identify the shares you're selling when you sell less than your entire holding of a stock or mutual fund. By notifying your broker of the shares you want sold at the time of the sale, your gain or loss from the sale is based on the identified shares. This sales strategy gives you better control over the amount of your gain or loss and whether it's long-term or short-term.

Consider a Bond Swap. Bond swaps can be an effective means of generating capital losses. With a bond swap, you start with a bond or bond fund that has decreased in value, which might be due to an increase in interest rates or a lowering of the issuer's creditworthiness. You sell the bond or fund shares and immediately reinvest in a similar (but not substantially identical) bond or bond fund. The end result is that you recognize a taxable loss and still hold a bond or shares in a bond fund that pays you similar or more interest than before.

Strategies for Your Business

Take Advantage of Bonus Depreciation. In an effort to spur the economy by motivating businesses to purchase new assets, the 2002 Tax Act Congress passed earlier this year includes some very favorable deprecation rules. New (not used) business assets acquired before September 11, 2004 are generally eligible for a special 30% first-year bonus depreciation deduction that is in addition to normal first-year depreciation. That's an immediate deduction equal to 30% of the cost of the asset. All business property, other than buildings and structural components, normally qualifies. This includes certain leasehold improvements, which can be a real boon for some lessors and lessees. One of the particularly attractive features of this new rule is that the additional 30% bonus depreciation is available regardless of when the property is placed in service during the year. Thus, property acquired and placed in service on the last day of the tax year is eligible.

Along the same lines as bonus depreciation, the 2002 Tax Act also raised the first-year depreciation limit on so-called luxury automobiles acquired before September 11, 2004. Again, only new property qualifies, but for 2002, the depreciation limit for qualifying vehicles is increased from $3,060 to $7,660. Thus, new vehicles placed in service before the end of the year qualify for the higher first-year depreciation limit.

So if you're thinking about purchasing new business property, it might make sense to go ahead and do so before the end of 2002. That way, you can enjoy not only the benefits related to using the new asset, but also a hefty tax write-off for 2002.

Employ Your Child (or Grandchild). If you are self-employed, don't miss one last opportunity to employ your child (or grandchild) before the end of the year. Doing so has tax benefits in that it shifts income from you to your child or grandchild, who normally is in a lower tax bracket or may avoid tax entirely due to the standard deduction. There can also be payroll tax savings since wages paid by sole proprietors to their children under the age of 18 are exempt from both social security and unemployment taxes. Employing your children has the added benefit of providing them with earned income, based on which they can then make an IRA contribution for the year. Children with IRAs, particularly Roth IRAs, have a great head start on retirement savings since these funds can grow significantly over a long period of time.

Remember a couple of things, though, when employing your child or grandchild. First, the wages paid must be reasonable given the child's age and work skills. Second, if the child is in college, or entering college soon, and if financial aid is a factor in the child's college attendance, having too much earned income can have a detrimental impact on the amount of aid the child might be eligible to receive.

Other Strategies to Consider

Retirement Plan Distributions. If you're age 70? or older, you're normally subject to the so-called minimum distribution rules with regard to your retirement plans (other than Roth IRAs). Under these rules, you must receive at least a certain amount each year from your retirement accounts. You can always take out more than the required amount, but anything less is subject to a 50% penalty on the shortfall amount. The tables for determining your required distributions each year are based on your (and, in some cases, your beneficiary's) life expectancy. The IRS recently revised these rules and tables, generally resulting in smaller required distributions for most taxpayers. Thus, if you haven't taken your required distribution for 2002, do so before year-end to avoid a hefty penalty. Also, if you're not basing your required distribution on the new IRS tables, it's probably to your advantage to do so.

If you turned age 70? in 2002, you can delay your 2002 required distribution to 2003 if you choose. But, waiting until 2003 will result in two distributions in 2003-the amount required for 2002 plus the amount required for 2003. While deferring income is normally a sound tax strategy, here it results in bunching income into 2003. Thus, think twice before delaying your 2002 distribution to 2003 because the bunching of income in 2003 might throw you into a higher tax bracket or have a detrimental impact on other tax deductions you normally claim.

Charitable Giving. You might want to consider two charitable giving strategies that can help boost your 2002 charitable contributions deduction. First, donations charged to a credit card are deductible in the year charged, not when payment is made on the card. Thus, charging donations to your credit card before year-end enables you to increase your 2002 charitable donations deduction even if you're temporarily short on cash or simply want to defer payment until next year. Note, however, that any interest paid with respect to the charge is not deductible.

Another charitable giving approach you might want to consider is the donor-advised fund. These funds essentially allow you to obtain an immediate tax deduction for setting aside funds that will be used for future charitable donations. With these arrangements, which are now available through various organizations including mutual funds such as Fidelity and Vanguard, you contribute money or securities to an account established in your name. You then choose among investment options and, on your own timetable, recommend grants to charities of your choice. The minimum for establishing a donor-advised fund is often $10,000 or more, but these funds can make sense if you want to obtain a tax deduction now but take your time in determining or making payments to the recipient charity or charities. These funds can also be a way to establish a family philanthropic legacy without incurring the administrative costs and headaches of establishing a private foundation

Leverage Your Kid's Tax Rates and Standard Deduction. It's not unusual for children to own investments in an account established by their parents or grandparents. However, there are two tax rules that are particularly onerous on children with taxable income who can be claimed as dependents: (1) their allowable standard deduction is reduced and they are not allowed a personal exemption deduction and (2) if they are under the age of 14, they are subject to the so-called kiddie tax, which can tax part of their investment income at their parent's tax rate rather than their own. While these rules certainly reduce the tax benefits of shifting income to a child, they don't completely eliminate it. For example, under the kiddie tax for 2002, the first $750 of a child's income is sheltered by the child's standard deduction and the next $750 is taxed at only 10%. For a child 14 or older, the same $750 standard deduction applies, but more income is taxed at the 10% rate-up to $6,000. In either case, the allowable standard deduction might be higher if the child has earned income.

It's likely your child can recognize up to $750 of investment income in 2002 without incurring a tax liability. Therefore, if your child has not already met this threshold for 2002, it might make sense to take steps to reach it, perhaps selling all or part of an appreciated security before year-end. If you like, you can immediately reinvest in the same security since the wash sale rule applies only to losses, not gains. Implementing this strategy each year can result in significant long-term tax savings since your child's investment tax basis essentially gets increased at no tax cost.

Conclusion

Taking the time now to review your 2002 tax situation gives you a chance to take advantage of many year-end tax saving opportunities. This letter highlights selected strategies, but there are many others that might also apply to your particular situation. We are here to help. If you would like to discuss the strategies mentioned here or other ideas for reducing your 2002 tax liability, please don't hesitate to call us. We would be pleased to set up a meeting within the next few weeks while there's still time to implement tax strategies before year-end.

Very Truly Yours,

CPA Advisory Group, Inc.

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