2002 YEAR-END TAX PLANNING

We noted major changes to the tax laws this year with a big bold NEW label.  Yes it seems not a year goes by that we do not have major changes and 2002 is no different. On top of all the new laws from the 2001 Tax Act that are being phased in we have a several new laws such as JCWAA – The Job Creation and Workers Assistance Act of 2002 which introduces many new tax changes.  Believe it or not we have tried to keep this short, we hope you find this of interest. 

Warning - K-1 Matching is back, as of November 2, the IRS has announced this program which was suspended this past May is back in full force with many enhancements.  If you get a notice regarding a K-1 reported on your return, please contact our office immediately. 

Warning – The IRS has begun the Taxpayer Compliance Audits, the super audits are very targeted and are designed to review every single item of a tax return and are the basis for how the IRS determines who will get audited in the future. These audits have not been done for over 15 years. The Director of the IRS's National Research Program (NRP) announced that the bulk of the audits would start in December 2002. He stated that IRS is not going to concentrate its efforts solely on high-income taxpayers. IRS has stratified high-income individuals into three categories:

• Income from $100,000 to $250,000

• Income from $250,001 to $1 million

• Income exceeding $1 million

The plan is to review only form 1040 returns in the first year, please call us ASAP if you get an audit notice this December or January. 

INDIVIDUAL TAX PLANNING 

General Overview.  One of the basic tenets of year-end tax planning is to “time” income and deductions to your tax advantage.  Typically, it makes sense to push taxable income to next year to defer payment of tax.  Similarly, you might accelerate deductions into this year to reduce the income tax bill you must pay by April 15th.  Of course, your personal circumstances may require a different approach.  All taxpayers benefit from the new 10% bracket carved out of the existing 15% tax bracket.  Here are the scheduled income tax rates for individuals in the highest tax brackets.

Year-end strategy:  All things being equal, you should follow the traditional strategy of deferring taxable income to 2003 and accelerating deductions into 2002.  Be sure to give us a call so we can help you coordinate the best strategy for you.  However, depending on your situation, income deferral is not always the best strategy.  For instance, if you will be in a higher tax bracket next year, you may not want to defer income.  It may make sense to accelerate income from 2003 into 2002 to benefit from a lower rate. 

NEW - Schedule B limit increased.  The filing requirement for Schedule B – Interest and Dividends has been increased from $400 to $1,500; this is the first increase since 1973, 29 years! Some things change each year, some things take a generation to change. 

Charitable Donations.  You can deduct the full amount of your donations of cash or checks made out to qualified charitable organizations.  This includes contributions to qualified organizations providing aid after the September 11th tragedy.  However, you cannot deduct donations made to a charity designed to benefit only one individual or family.  You can deduct a pledge made by credit card this year on this year’s return — even if you don’t pay the charge until next year.  This is a good example of accelerating deductible items into the current year.  If you donate property to a qualified charitable organization, your deduction is generally limited to your basis in the property.  However, if the property would have qualified for long-term capital gain if it had been sold (i.e., you’ve held it for more than one year), you can deduct the fair market value of the gift on the date of the donation.  You must have a written acknowledgement of all gifts of $250 or more and an appraisal for gifts of property in excess of $5,000. 

Interest Expenses.  The deductibility of interest expenses generally depends on the use of the loan proceeds. For instance, the deduction for interest expense of funds used for investment purposes is generally limited to the amount of your investment income, while personal interest expenses such as for most credit card charges are completely nondeductible.  On the other hand, qualified mortgage interest expenses may be fully deductible, regardless of the use of the proceeds.   When it is appropriate, you might arrange a home equity loan or line of credit to reduce the after-tax cost of borrowing.  The deduction for “home equity debt” is limited to interest paid on the first $100,000 of debt when allowed by state law.  By using this strategy, you can convert otherwise non-deductible personal interest into deductible mortgage interest. 

NEW  - Taxpayers can also claim an above-the-line $2,500 deduction for student loan interest.  The deduction is phased out for joint filers with a modified adjusted gross income (AGI) between $60,000 and $75,000 ($40,000 and $55,000 for single filers).  Among other changes, the new tax act increases the phase-out range for student loan interest to $100,000 and $130,000 for joint filers ($50,000 and $65,000 for single filers).   

Warning - Home Mortgage Refinancing. The IRS issued Notice IR-2002-114 to remind taxpayers that they may be eligible to deduct mortgage-refinancing costs over the life of the loan. For a refinanced mortgage, the interest deduction for points is determined by dividing the points paid by the number of payments made over the life of the loan. Taxpayers may deduct points only for payments within in the taxable year. However, if a portion of the refinanced mortgage money was used to finance home improvements and if the taxpayer meets certain other requirements, the points associated with the home improvements may be fully deductible in the year the points were paid. For mortgages refinanced a second time, the balance of points paid for the first refinanced mortgage may be fully deductible at pay off. Closing costs, such as appraisal fees and other no interest fees, are generally not deductible. The IRS continues to make this area more complicated. 

Alternative Minimum Tax.  The alternative minimum tax (AMT) applies if a special tax calculation exceeds your regular tax liability.  As part of the computation, you’re entitled to a special exemption based on your filing status.  The AMT is designed to ensure that individuals who benefit from an overabundance of “tax preference” items and certain other tax breaks pay their fair share of overall tax.  The ATM rate is 26% for the first $175,000 of AMT income; 28% on any excess above that amount.  To avoid the AMT, try to postpone tax preference items to next year, when it’s possible.  However, if you’re certain you will have to pay the AMT this year, you might accelerate income into this year if you’re in a high regular tax bracket. Note – this law has not been updated since the creation in the early 1980’s; the effect of this is that more and more taxpayers are caught by the AMT.  Some items which can push taxpayers into AMT are: Home Mortgage Interest, Investment Interest, Taxes such as real estate taxes, state and local taxes.  Children, yes even children can trigger the AMT tax, it is predicted that within 5 years 85% of families with 4 or more children will be subject to the AMT tax. 

Medical and dental expenses are deductible only to the extent the annual total exceeds 7.5% of your AGI.  If you expect to clear the threshold this year, any additional costs you incur this year will be deductible.  By scheduling routine exams and non-emergency procedures before year-end, you can increase your deduction. 

Miscellaneous expenses are deductible only if the annual total exceeds 2% of your AGI.  You might move up certain expenses (e.g., un-reimbursed employee business expenses) if you expect to clear the 2% mark this year. 

Education Credits and Deductions are valuable because the cost of college continues to increase faster than inflation.  However, you may be able to remove some of this financial burden by claiming tax credits and deductions when appropriate.  You may claim the Hope Scholarship credit for the first two years of college education.  The maximum credit is $1,500 per year per child.  The credit phases out for joint filers with an AGI above $82,000 ($51,000 single).  You can claim the Lifetime Learning credit in any year in which the Hope Scholarship credit is not claimed.  The maximum credit of $1,000 ($2000 in 2003) phases out at same levels as the Hope Scholarship credit. 

NEW - You can take an above-the-line deduction up to $3,000 for college tuition.  This is available to joint filers with an AGI below $130,000 ($65,000 for single).  You can deduct up to $2,500 of the interest you pay on a student loan.  For 2002, the full deduction is available to joint filers with an AGI below $100,000 ($50,000 single).  Only the taxpayer required to repay the debt may claim the deduction for student-loan interest.  Because of the AGI limits, it may be beneficial to have your child take out student loans in his or her own name.

Dependency exemptions can be claimed for certain relatives if you provide more than half of their annual support.  Unless the relative is a child under age 19 at the end of the year or a full-time student under age 24 at the end of the year, the relative cannot have more than the personal exemption amount ($3,000) in taxable income.  

Estimated tax penalties can be avoided if your payments this year, including withholding payments at a job, equal at least 90% of your current tax liability or 100% of the previous year’s tax liability (110% if your AGI was more than $150,000). 

Transferring Investments.  With the 10% tax bracket, there is a tax incentive to transfer investment property to young family members.  If you’re in the 35% bracket and your child is in the 10% bracket, you can save $250 on $1,000 of investment income.  Caution: annual investment income above $1,500 received this year by a child under age 14 is taxed at your top marginal rate under the “kiddie tax” provisions. 

FINANCIAL TAX PLANNING 

General Overview.  The ultimate goal of tax planning is to hold on to as much of your money as possible.  Year-end financial tax planning represents a valuable opportunity to accomplish your goals.  The following information offers a few practical methods to keep more of your hard-earned dollars. 

Capital Gains and Losses.  The end of the year provides a unique opportunity to “time” capital gains and losses, especially for securities.  As a general rule, capital losses can offset capital gains plus up to $3,000 of ordinary income.  The maximum tax rate for capital gains is 20% if the asset has been held for more than one year. 

Important Year-End Evaluation.  Due to the market decline, you may be holding securities showing paper losses.  As a result, you might realize capital losses that can offset gains realized earlier in the year.  Conversely, any gains you realize now may be absorbed by losses realized this year.  This also includes mutual funds that may have recognized gains or losses. 

The “Wash Sale” Rule.  If you are selling stock or mutual fund at a loss, you must be aware of the “wash sale” rule.  Briefly stated, you cannot deduct a loss on the sale of securities or mutual fund if you buy back substantially identical securities within 30 days of the sale.  One way to avoid the wash sale rule without dramatically affecting the asset allocation of your portfolio is to immediately purchase a similar, but not identical, security or mutual fund to the one you sold at a loss.  Another way to avoid the wash sale rule is to double up on your shares now and sell the original shares 31 days later.  Make sure the transaction is completed this year.  

Traditional IRA Plans.  Basic rules for traditional IRA contributions are unchanged. You cannot fully deduct contributions if your annual AGI exceeds a specified dollar limit AND you’re an active participant in an employer-sponsored retirement plan.  The limit for joint filers in 2002 is $54,000; $34,000 for single.  Whether or not your contributions are deductible, you may contribute up to $3,000 to an IRA, in addition to any qualified plan contributions made on your behalf.  Under the new tax act, however, there is an extra $500 “catch-up contribution” if age 50 or over.  These limits will increase:

Roth IRA Plans.  Basic rules for Roth IRAs also remain unchanged.  Roth IRA contributions are non-deductible, but distributions may be tax-free for amounts held at least five years.  The contribution limits for Roth IRAs are the same as the limits for traditional IRAs. For 2002, you can contribute up to $3,000 to a Roth IRA plus a $500 catch-up contribution if age 50 or over, provided your AGI does not exceed $150,000 married ($95,000 for single). 

NEW - Coverdell Education Savings Account.  The ESA, formerly known as an Education IRA, enables you to save additional money for a child’s college education.  If the funds are used to pay for higher education, distributions are tax-free.  However, contributions are not tax deductible.  The annual contribution limit for a Coverdell ESA has quadrupled from $500 to $2,000, beginning in 2002.  Furthermore, contributions for joint filers now begin to phase out at an AGI of $190,000 (up from $150,000 for 2001).  The AGI limit for single filers remains at $95,000.  You can now use Coverdell ESA to pay for qualified elementary and secondary school expenses, as well as higher education. 

Qualified Retirement Plans.  If you participate in a qualified retirement plan at work, the funds in your account can accumulate without any current tax erosion.  Depending on the type of plan, contributions may be made by the employer or the employees - or both.  Among other modifications, provisions increase the amounts that may be contributed to several types of qualified plans.  Both employees and employers should assess current arrangements in view of scheduled increases for 2002:  

401K Plans.  One of the most popular employer-sponsored retirement plans is the 401(k) plan. With a 401(k), you can defer part of your salary to an account where the funds can grow on a tax-deferred basis. In addition, your company may agree to match a portion or all of your annual contributions.  A 401(k) must meet strict nondiscrimination requirements to maintain its tax-favored status. Besides these requirements, there is an annual dollar cap on contributions. The limits for the next few years are: 

Year-end Tip: You can adjust your 401(k) plan contributions at year-end to increase your retirement nest egg. For instance, you may allocate more dollars to your 401(k)account after you clear the Social Security wage base ($84,900 for 2002). 

Defined Contribution Plans.  Beginning in 2002, the annual limit on annual additions to a defined contribution plan is increased to $40,000 (up from $35,000). 

Defined Benefit Plans.  Effective in 2002, the annual wage limit for benefits in a defined benefit plan rises from $140,000 to $160,000. 

SIMPLE Plans.  Currently, the limit for contributions to a Savings Incentive Match Plan for Employees (SIMPLE) is $7,000 a year. This limit will gradually increase in $1,000 increments to $10,000 for 2005 and thereafter. 

Compensation Consideration.  The maximum amount of compensation taken into account for qualified plan purposes is $200,000 in 2002, up from $170,000 last year. 

Profit Sharing.  Beginning in 2002, an employer’s deductions for contributions to profit-sharing plans and stock bonus plans may equal 25% of compensation (up from 15%).

MISCELLANEOUS ITEMS 

Bond Swaps.  Depending on your situation, you might arrange to “swap” municipal bonds in the secondary market at the end of 2002. As long as the bond characteristics are not “substantially identical,” there is no current income tax on the exchange. 

Fund Sales.  From a tax viewpoint, it’s beneficial to sell shares before a mutual fund declares dividends at year-end and to buy shares after the fund declares dividends. 

Passive Activities.  Losses from passive activities such as rental real estate may only be used to offset income from other passive activities (with limited exceptions).  You might invest in a passive activity to generate income to absorb existing losses, or you might sell rental property to offset losses that are otherwise unusable. 

New Cars.  The “luxury tax” on autos has decreased from 4% of the amount above $38,000 to 3% of the amount above $40,000, saving $380 on a $70,000 car.   

Charitable Planning.  The IRS has cracked down on charitable remainder trusts (CRTs) that are considered “abusive” in nature or otherwise designed to skirt the tax laws.  However, a CRT or other charitable gift transaction may still fit into your overall estate plan.  For example, a gift to a charity might be combined with a “Wealth Replacement Trust” that uses life insurance to replace the amount gifted. 

Variable Life Insurance and Annuities.  You may re-align the investments within these contracts without any tax liability, and often at no expense.  This may be an appropriate move, due to market volatility.  When considering your entire portfolio, don’t forget the values in these plans, which may be substantial.    

Estate Tax Issues.  Although the 2001 tax act repealed the federal estate tax, this change does not take effect until 2010 - if ever.  Therefore, reducing the size of your estate through lifetime gifts is still critical.   

Other Family Members.  Don’t forget the need for tax planning by other members of your family.  It might be a good idea for you to forward a copy of this Year-End Tax Planning Memo to them – or give us a ring, and we will be happy to do so for you. 

Family Gifts.  Anyone can give another individual up to $11,000 annually without incurring any gift tax liability. The gift is excluded from income by the recipient and is not deductible by the donor. This is an excellent way to shift assets from a high-income parent to a low-bracket child. The recipient then pays tax on any earnings from the investment of the gift.  Furthermore, a direct payment of medical expenses or tuition for another person is not considered a gift for gift tax purposes. To qualify, payment must be made directly to the school or medical provider and not to the beneficiary.  For 2002, you can gift $11,000 per recipient, to as many recipients as you like, without paying any gift tax.  The gift maximum is doubled to $22,000 for joint gifts by a married couple. 

BUSINESS TAX PLANNING

General Overview.  With the new lower tax rates for individuals, if you are starting a new business, it is more important than ever to consult a tax professional.  By accelerating deductible expenses, you can increase your deductions this year. 

Corporate Income and Deductions.  Although there is less flexibility in year-end tax planning for corporations than there is for individuals, opportunities do exist.  As with your personal situation, it is generally advantageous for a corporation to defer income and to accelerate deductions.  For example, you might stock up on routine supplies and postpone billings in late December.  Tax rates for C corporations are: 

Since tax rates for individuals are being reduced, you might want to elect S corporation status if your company is taxed at a high tax rate.  Unlike C corporations, where income is effectively taxed twice (once on the corporate level and once to the individual), there is no corporate level tax on S corporation shareholders.  You have until 2 ½ months after the close of the tax year to make a valid S corporation election for the current year. 

Depreciation Deductions.  Under the “half-year convention,” you can claim the equivalent of a half-year’s depreciation deduction for an asset placed in service this year—regardless of when the asset is actually placed in service.  This creates a tax incentive to purchase equipment and other business assets at the end of the year.  Watch out for a potential tax trap.  If the cost of business assets placed in service during the last quarter of the year exceeds 40% of the cost of all assets placed in service during the year, you must follow the mid-quarter convention.  This calculation generally results in smaller depreciation deductions for the year.  In lieu of claiming depreciation deductions, you may be able to use the “Section 179 election” to currently write off some or all of your annual cost.  Under this special election, the maximum allowance is $24,000 ($25,000 in 2003).  Result: the election can be coordinated with depreciation deductions to avoid the last-quarter tax trap. 

Travel and Entertainment Deductions.  The IRS tends to scrutinize deductions for travel and entertainment (T&E) expenses. As a result, you must take extra care to ensure that you follow all the special rules in this area.  Deductions for entertainment and meal expenses are limited to 50% of the cost.  However, this restriction does not apply to a company party for all employees.  Un-reimbursed T&E expenses are treated as miscellaneous expenses that are deductible on the employee’s tax return and subject to the usual 2% limit. 

Car expenses for business travel.  Be aware that depreciation deductions are reduced for “luxury cars.”  In lieu of deducting actual expenses, you may claim a standard mileage deduction of 36.5 cents per business mile.  Caution: if you elect the standard mileage method for a car this year, you can’t reverse it next year.  The IRS has announced the 2003 deduction will be 35.5 cents per mile.  The new 2002 tax act boosts the first-year dollar cap for luxury cars form $3,060 to $7,660-more than twice the previous limit.  This new tax incentive applies to cars purchased after September 11, 2001 and placed in service before 2005.  The annual depreciation deduction for a “luxury car” is limited.  For 2002, the limits apply to any car costing more than $15,300. 

Spouse Accompaniment.  No deduction is allowed for a spouse who travels with you on business.  However, if you hire your spouse as an employee to assist you (in a bona fide business purpose) on a business trip, his or her expenses are deductible.  

Accountability for Records.  Both employers and employees must observe strict record keeping and reporting rules. The rules are simplified if your company uses an “accountable plan” to reimburse employees. 

Year-End Bonuses.  Compensation is deductible by the employer and taxable to the employee in the year it is paid.  However, there is a special rule for year-end bonuses paid by an accrual-basis company.  If the corporation pays a bonus to an employee within 2 ½ months after the close of the tax year, it is deductible on the corporation’s current tax return - even if still taxable to the employee in the following tax year.  If your company is a calendar-year corporation, determine bonus amounts for employees and arrange to pay them in 2003.  The reasons for the bonuses should be spelled out in the corporate minutes.  Note that this technique does not work for majority shareholders of a C corporation, employee-shareholders of an S corporation or employee-owners of a personal service corporation, where the bonus is deductible only in the year it is paid. 

Maintenance. If your company takes care of repairs before the end of the year, the repairs are deductible on the current return.  The cost of “improvements” that add to a property’s value or prolong its useful life must be capitalized.  Caution: if improvements and repairs are made simultaneously as part of an overall plan, the entire cost is capitalized.  To avoid potential problems, handle repairs and improvements separately. 

Charitable Contributions.  If your company donates assets to charity, the deduction is generally limited to your basis in the property.  However, if a company (other than an S corporation) donates inventory-type property to certain charities, it may deduct its basis for the property plus one-half of the asset’s unrealized appreciation.  The deduction can’t exceed twice your basis in the property.  Charitable contributions are limited to a percentage of earnings – perhaps it might be better to advertise in their publications.  If your corporation does not have a taxable profit, or only a small one, and you still wish to benefit a charity, then make payments for an advertisement, such as in a program booklet or purchase event tickets and distribute them to employees or customers as business promotion expense.  If the amount is large, consult your business tax advisor. 

Inventory Accounting.  When the cost of goods rise, using the LIFO (Last-In, First Out) method of inventory accounting may be favorable.  This method can result in a larger deduction for cost of goods sold, in turn, creating a lower taxable income.  The tax benefit continues as long as costs continue to increase. 

Bad Debts and Non-Collections.  Your business can claim a bad debt deduction in the year a debt becomes totally worthless.  Take steps to collect bad debts at year-end and keep track of your efforts to prove the worthlessness of debts.  

Conclusion:  This Year-End 2002 Tax Planning Memo is to be used as a general guideline and a stimulus for your review at this time.  It distills thousands of pages of legislation and regulatory guidelines.  Your personal circumstances may require special attention.  Many of the tax-saving moves outlined in this memo are subject to special rules.  Professional help is strongly recommended for decisions.  We would be glad to schedule a year-end planning meeting to develop steps that meet your objectives.

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We do not offer legal advice. All information provided on this website is for informational purposes only and is not a substitute for proper legal advice. If you have legal questions, we recommend that you seek the advice of legal professionals.

Tax Disclaimer: To ensure compliance with IRS Rules, any U.S. federal tax advice provided in this communication is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer (i) for the purpose of avoiding tax penalties that may be imposed on the recipient or any other taxpayer under the Internal Revenue Code, or (ii) in promoting, marketing or recommending to another party a partnership or other entity, investment plan, arrangement or other transaction addressed herein.

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Last modified: January 30, 2017