2004 Year-End Tax Planning
 
November 24, 2004
 

After the 2004 Presidential election, President Bush announced that tax reform is a top priority for his second term. The administration is weighing a revenue-neutral shift to a “flat tax” or consumption tax and a “permanent” repeal of the federal estate tax. Tax simplification is the stated objective, but the shape and form of the final package that emerges from Congress will undoubtedly be the product of heated debate, zealous lobbying and hard fought negotiations. The likely winners and losers remain to be seen, but with a huge budget deficit, the war in Iraq, efforts to curb terrorism in other places around the world, and a health care system in need of reform, it will be worth your while to follow these proceedings closely.

For now, with 2004 rapidly coming to an end, we would like to remind you of some of the steps you can take in the weeks that remain to minimize your 2004 income taxes.

The technique of accelerating deductions in the current year and deferring income to subsequent years continues to be beneficial for most taxpayers with one very important caveat. The federal alternative minimum tax (AMT) continues to apply to a number of individual taxpayers, especially those residents of high-state- tax jurisdictions, such as Massachusetts, New York and California. For those of you not familiar with the AMT, it is an entirely separate income tax computation originally intended to impose an annual minimum income tax obligation on taxpayers who take advantage of a variety of special income tax deductions and benefits.

Today, as a consequence of recent tax-rate deductions and increased itemized deductions, more and more individuals are subject to the AMT. In these cases, the application of the general principal may not be the best approach and there could well be tax benefits for accelerating income to the current year and deferring deductions to subsequent years. Given the complexity of the AMT, often the only way to determine if it applies and if there are income tax planning opportunities available is to have a tax advisor prepare alternative income tax projections for both the current and future years. Using these projections, an individual may be able to minimize his AMT liability without increasing his regular income tax liability.

For several years, individual taxpayers had been entitled to an AMT exemption amount, which varied depending on the individuals’ taxpayer status. This limited relief had been set to expire after 2004. The 2004 Working Families Act extended the AMT exemption to 2005. It is quite possible, given the increasing number of taxpayers subject to the AMT, that further extensions will be enacted in future years unless and until Congress reconsiders the application of the AMT and makes some changes in it. If no corrective action is taken, the number of taxpayers affected by the AMT will increase from 3.4 million in 2005 to 18.6 million in 2006, according to a recent Wall Street Journal article.

As individuals review their deductions for 2004, several changes enacted by the American Jobs Creation Act of 2004 should be considered. First, Congress reinstated an itemized deduction for state sales and use taxes for 2004 and 2005, which had been eliminated in 1986. This is a modification of the existing state income tax itemized deduction and will provide a benefit for residents of states like Florida, Texas and Washington, with limited or no individual state income taxes, but relatively high state sales and use taxes. Individuals will be able to deduct the higher of either their state and local income tax payments or their state sales and use tax payments. Sales and use tax payments will be determined by either special tables presumably based on an individual’s income level and filing status to be published by the IRS or actual sales tax payments for the year in the case of major purchases such as a car or boat.

If an individual is considering several major purchases over the remainder of 2004, all of which would be subject to sales tax, it may be advantageous to make all of those purchases in 2005, if the aggregate sales tax obligation could be increased and a larger deduction claimed in 2005. It is possible in the future that this new state sales tax deduction would be either extended beyond 2005 or made permanent. Regardless, individuals contemplating changes in their purchasing plans should not ignore the AMT consequences of this additional deduction and the limitation imposed on an individual’s itemized deductions which, in turn, would limit the benefit of this deduction.

Second, for those individuals who donate their automobiles, boats and planes to charity and claim a charitable contribution for the fair market value of the donated property, because of perceived taxpayer abuses, the American Jobs Creation Act of 2004 enacted tougher substantiation rules. The new rules will apply to these types of charitable donations after 2004 if the claimed deduction exceeds $500. Therefore, if you are considering such a donation, it may be better to take this deduction prior to the end of 2004 to avoid the new substantiation requirements.

Although not a new provision, often individuals fail to consider the income tax benefit of a casualty on deductions. Many of our individual clients own property in areas that have been damaged by the recent string of hurricanes and storms, which struck the eastern and gulf coasts earlier this year. Such individuals should consider if their economic loss, after any property and casualty insurance recovery or government recovery grant, could qualify them for a casualty loss for federal income tax purposes. In order to ensure that a significant casualty loss had been suffered, the net casualty loss deduction would be allowed only to the extent that the net casualty loss exceeds 10% of the taxpayer’s adjusted gross income for the year. Regretfully, some of our clients and friends may have suffered losses of this magnitude due to these severe storms. The casualty rules are quite complex, but if a person is eligible, a significant income tax savings could be realized.

Last year we discussed the significant income tax savings available to individuals as a result of the decline in income tax rates and other changes resulting from the Jobs and Growth Tax Relief Reconciliation Act of 2003. For additional information, see our Winter 2003 Newsletter, “New Tax Law with Reduced Rates Offers Opportunities-Income, Dividends, Capital Gains, Business Investments, 401(k)s, All Winners.” ¹ Most of these rate reductions continue to apply and will remain available to taxpayers in 2004 and 2005. For most taxpayers, the highest federal regular income tax rate on most dividends will remain at 15%. Also, the favorable maximum rate on most types of capital gain will remain at the same 15%. Investors should continue to monitor their investment portfolios and evaluate if additional tax savings could be realized, with minimal additional risk, by purchasing stocks that have a high dividend yield.

For estate planning purposes, each year we remind individuals, who wish to make gifts to children, grandchildren and other family members, to take advantage of their annual gift tax exclusion amount, currently $11,000 per year per donee, for gifts of a present interest. With spousal gift splitting, the amount increases to $22,000 per year per donee. For example, a set of grandparents could transfer to a child, the child’s spouse and two grandchildren, a total of $88,000 without any use of the taxpayer’s $1,000,000 lifetime gift tax exemption. Annual exclusion gifts of this type made over several years represent a significant estate tax savings. In addition, the direct payment of a family member’s tuition costs at most educational institutions or the direct payment of a person’s medical expenses qualify as additional gifts, which are not subject to any gift taxes, without any limitation on the amount of the gift. For additional information see our Winter 2003 Newsletter, “Act on These Year-End Tax Planning Resolutions Before the New Year.” ²

As noted at the outset, President Bush would like to make permanent the repeal of the estate tax currently in effect for only the year 2010. In the event of such a repeal, estates will receive only a limited step-up in the basis of a decedent’s assets and, in effect, the estate tax will be replaced by a capital gains tax. A number of commentators have suggested that a more equitable approach with less income tax complexity is to preserve the federal estate tax but continue to increase the exemption, for example to $5,000,000, with indexing for inflation. A number of states, not including Florida, have not followed the federal estate tax and, in fact, now impose a state estate tax in cases where there is a full federal exemption. We refer to this as “de-coupling”. See Winter 2003 Newsletter, “Increased Estate Tax Exemption and De-Coupling of Federal and State Estate Taxes May Create Results You Did Not Intend.”³ If the federal estate tax repeal is extended and states, primarily due to budgetary considerations, continue to impose an estate tax, estate planning will continue to be intellectually challenging and financially rewarding. “Stay tuned” to future newsletters for further developments.

For more information, e-mail Jeffrey Levin at jeffrey.levin@hklaw.com or call toll free, 1-888-688-8500.

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¹ You may access the article online at http://www.hklaw.com/Publications/Newsletters.asp?IssueID=413&Article=2340.

² You may access the article online at http://www.hklaw.com/Publications/Newsletters.asp?IssueID=413&Article=2339.

³ You may access the article online at http://www.hklaw.com/Publications/Newsletters.asp?IssueID=413&Article=2342.