Income Tax Planning
 
November 29, 2005
 
Bradley Van Buren - Boston

In 2005, Congress has been confronted with the onerous task of providing tax relief to aid and protect those affected by the recent catastrophic events and encourage energy conservation through tax credits, while attempting to control a seemingly insurmountable deficit and maintaining sufficient revenue to fund a war in Iraq; rebuild the Gulf and other areas touched by disaster; and improve domestic programs, such as health care, that remain ripe for reform.  Meanwhile, the President’s Advisory Panel on Federal Tax Reform is debating ways to simplify and, in some cases, eliminate certain facets of the current income tax system.

Despite the changing economic landscape and continuing tax policy debate, as we approach year-end, taxpayers must remain focused on their personal income tax liability and those tax saving techniques that may alleviate the inevitable financial burden many associate with April 15.  The 2005 year-end tax planning approach includes several of the same techniques used in previous years to address the federal alternative minimum tax (AMT), capital gains and retirement planning, but also incorporates some of the new options taxpayers have as a result of the Hurricane Katrina relief package.

Alternative Minimum Tax     

When AMT was enacted in 1969, it was originally designed to safeguard against the “very wealthy” exploiting certain tax incentives to avoid paying income tax.  However, due to a failure to adequately index available AMT exemption amounts for inflation along with a phase-out provision for higher income tax earners and the recently reduced marginal rates, the number of taxpayers subject to AMT will dramatically increase over the next decade.  Current forecasts by the Congressional Budget Office estimate that about two-thirds of households between $50,000 and $100,000 and over 90 percent with incomes between $100,000 and $500,000 will be subject to AMT before the end of the decade unless a legislative change is enacted.  In a recent Wall Street Journal article, it was reported that the Treasury Department estimates the AMT will affect about four million people this year, and that this number will soar to more than 21 million next year unless Congress changes the law.  Therefore, it is imperative that taxpayers consider the potential application of the AMT as year-end approaches.

Those taxpayers that may be particularly vulnerable to the AMT are taxpayers that live in states with high income taxes (such as California, New York, Montana, Oregon and Vermont); high property taxes (such as New York, Illinois and New Jersey); and deductible personal exemptions.  Other taxpayers prone to the AMT include those with large long-term capital gains or qualified dividends, large miscellaneous deductions, large deductions for accelerated depreciation and taxpayers who have exercised incentive stock options (the bargain element of an incentive stock option is not subject to ordinary income tax when exercised, but is subject to AMT). 

To adequately plan for the AMT, a taxpayer should not only project his or her income for the current year, but for the next two years as well.  Many of the techniques that may be utilized to avoid or alleviate the AMT entail the acceleration of income or the deferral of certain deductions that the AMT calculation does not recognize and should only be considered with the advice of a qualified tax advisor.  For instance, if based on the projections, a taxpayer expects to be subject to the AMT in 2005 but not in 2006, he or she should consider accelerating ordinary and short-term capital gains income and deferring certain non-AMT deductions, such as state and local income taxes, real estate taxes and investment advisory fees, to 2006.  Although this concept may seem counterintuitive to general tax planning principles, the imposition of the AMT rates on the ordinary and short-term capital gains income may provide a better tax result than if the taxpayer’s regular marginal rates applied.  Conversely, if the projections determined that the taxpayer would not be subject to the AMT in 2005, but is likely to be subject to the tax in 2006, he or she should consider accelerating expenses that are not deductible for AMT in 2005.  For instance, a taxpayer may want to prepay state income tax, property tax or home equity debt if the interest expense is not deductible for AMT purposes.

Capital Gains and Qualified Dividends

As in previous years, a taxpayer should evaluate his or her capital gains transactions from the sale of investments and consider offsetting gains with year-end sales of capital investments that have a history of underperforming and will most likely produce capital losses.  Although the current long-term federal capital gains rate generally remains at a favorable 15 percent, strategizing the timing of a taxpayer’s capital loss recognition not only alleviates a taxpayer’s overall tax liability but also may inspire a much needed rebalancing of an investment portfolio.  In addition, it is also important to note that losses taken in excess of gains may offset ordinary income up to $3,000 ($1,500 for married individuals filing separately) and any remaining amount may be carried forward.

Due to the capital gains and qualified dividend rate differential between taxpayers in the two lowest tax brackets (5 percent) and those in the highest four tax brackets (15 percent), taxpayers should consider transferring dividend producing appreciated stock to their children or grandchildren.  The recipient will take the taxpayer’s basis in the stock transferred; however, if the recipient is over the age of 13 and in the lowest two tax brackets, the transfer could result in an immediate 10 percent tax savings on both capital gains and any dividends received following the transfer. Assuming the taxpayer has properly planned with his or her tax advisor to ensure that the transfer qualifies for the annual gift tax exclusion (and the annual generation-skipping transfer tax exclusion, if applicable), he or she will have successfully alleviated his or her tax liability, reduced the overall tax effect on the transferred asset and satisfied a family wealth transfer objective.

Further, it is important to note that taxpayers may elect to treat capital gains and qualified dividends as investment income, which is taxed at ordinary income rates, if they have deductible investment interest expense available to offset it.  Investment interest expense is only deductible to the extent of current year net investment income.  Since capital gains and qualified dividends are not considered investment income for this purpose, a taxpayer may want to consider electing to recognize enough capital gains or qualified dividends as investment income to maximize the use of any available investment interest deduction while maintaining the character of any remaining capital gains and qualified dividends, which will continue to be taxed at the more favorable tax rates.

Retirement Planning

Contributions to traditional individual retirement accounts (IRAs) and qualified retirement plans are an essential component of a successful financial plan that also may provide an opportunity to reduce the taxpayer’s current tax liability.  A taxpayer should consider contributing to his own IRA, or a spousal IRA if his or her spouse has little or no earned income and is not currently participating in an employer-sponsored retirement plan.  The maximum contribution that can be made to each IRA is $4,000 for 2005 ($4,500 for individuals who have reached age 50), which may be applied retroactively if made before the tax filing deadline.  However, the deduction for such contributions is phased out for married couples filing jointly who have adjusted gross income between $150,000 and $160,000.  Despite the loss of the tax deduction, the amounts contributed to the IRA will be permitted to grow in a tax-deferred manner; thereby still providing a good retirement planning option.  Similarly, a taxpayer may want to consider a contribution to a Roth IRA if he or she is not restricted by the income limitations.  Although contributions to a Roth IRA are not deductible for tax purposes, the income earned in the account may be free of federal income tax when the taxpayer makes withdrawals.

To take advantage of the benefits of a Roth IRA, which, in addition to tax-free earnings, also includes the option of making additional contributions to the account after age
70-1/2 and the avoidance of the mandatory distribution rules applicable to IRAs during the owner’s lifetime,  a taxpayer may want to consider converting an existing IRA to a Roth IRA.  Although the conversion will result in an immediate tax recognition, the added benefits of a Roth IRA described above may make this a useful wealth transferring vehicle.  Only individuals with modified adjusted gross income below $100,000 may convert their IRAs to Roth IRAs.  However, unlike previous years, in 2005, any minimum required distribution amounts received by the individual from IRAs will not count toward the $100,000 limitation.

Contributions to a qualified retirement plan, such as an employer-sponsored 401(k) or 403(b), are funded with pre-tax money and therefore are not includible in the taxpayer’s gross income.  The maximum contribution to a qualified retirement plan is $14,000 for 2005 ($18,000 for individuals who have reached age 50) and such elections must be made before the end of the calendar year.  Similar to an IRA, the account grows tax-deferred; therefore, the taxpayer is not taxed on his or her contributions and earnings until the taxpayer makes a withdrawal from the account.  The year-end retirement planning analysis should also consider options for the upcoming year.  When doing so, it is important to note that in 2006 an individual may be permitted (if offered by his or her employer plan) to allocate a portion or all of his contributions to a Roth 401(k) or 403(b).  As with a Roth IRA, the contributions will be made with after-tax money but the distributions may be taken free of federal tax. 

The Hurricane Katrina Relief and Charitable Deductions

On September 23, 2005, President Bush signed into law an expansive relief package for the victims of Hurricane Katrina.  The package includes a temporary change to the tax law regarding charitable gifts that should be considered as part of a taxpayer’s year-end planning.  While, under the existing law, the maximum amount deductible in any one year is 50 percent of adjusted gross income, that limit is being increased to 100 percent for cash gifts made to public charities from August 28 to December 31, 2005.  In addition, gifts will not be subject to the tax reduction rules that reduce itemized deductions by 3 percent of the amount by which adjusted gross income exceeds $145,950.  It is important to note that a contribution to a private foundation, a supporting organization, a donor advised fund or gifts of property such as stock or land do not qualify for the higher limit.

As a result of this legislation, an individual is afforded the opportunity to use withdrawals from IRAs or qualified plans to satisfy the charitable cash gift without incurring any additional tax liability.  For instance, since the limit has been increased to 100 percent of adjusted gross income for this time period, a distribution taken during 2005 and contributed to a public charity on December 1, 2005 will be entirely includible in the individual’s adjusted gross income, but the individual will be permitted to fully deduct the charitable contribution; thereby resulting in a “wash.” However, there are potential adverse tax consequences which must be considered in connection with this strategy and it is advisable to obtain pro forma projections of the after tax consequences prior to taking action.

In addition, the Act provides several other provisions relevant to businesses and individuals.   From a business perspective, the Act waives the 10 percent income limitation for charitable cash contributions made by corporations for Hurricane Katrina relief efforts and increases the deduction for food inventory donations made by C corporations, S corporations, partnerships and sole proprietorships.  For individuals, the Act permits an increased deduction for the use of a personal vehicle for Hurricane Katrina relief and a waiver of the 10 percent penalty on early distributions from IRAs and pensions for those affected by the hurricane.  Please note that this is not an exhaustive list of the provisions of the Act and a tax advisor should be consulted if you were either directly affected by the hurricane or contributed to the relief efforts.

Federal Tax Reform

Over the past six months, the President’s Advisory Panel on Federal Tax Reform has been debating possible ways to reform the federal income tax system in an effort to simplify it.  Although many of the details have not yet been disclosed, the nine-member panel has recently released the general direction of the panel and some of the proposals being considered.  For instance, it has been suggested that the AMT be repealed and that the income tax rates be simplified by reducing the number of individual tax rates from six to four:  15  percent, 25 percent, 30 percent and 33 percent.  As with other recent tax legislation, the panel is also considering making stock ownership more attractive by effectively reducing the capital gains rate and eliminating income taxes on dividends.  Another consideration is to eliminate or limit certain currently available deductions.  For example, the panel is suggesting the following:  eliminating the deductions for state and local tax, casualty losses and medical expenses; imposing new limits on home mortgage interest and charitable deductions and the amounts of health insurance that can be provided tax-free by employers; and permitting a deduction for individuals who buy health insurance. These proposals must still be reviewed and considered by Congress.

Conclusion         

Year-end income tax planning is a complicated and necessary analysis that every taxpayer should endure.  With the assistance of a qualified tax advisor and an understanding of the current planning options and pending law changes, a taxpayer can greatly reduce his or her tax bill.  The process should not only entail a discussion of this year’s income and options, but should also incorporate projections for the next two years to provide the most effective planning.

For more information, e-mail Bradley M. Van Buren at bradley.vanburen@hklaw.com or call toll free,
1-888-688-8500.