TAX BUSINESS STRATEGIES Plan Now for Roth Conversions INSIDE

TAX&BUSINESS STRATEGIES Plan Now for 2010 Roth Conversions FALL2006 INSIDE: # Are You Making Free Government Loans? # Capital Gains & Dividends Bargain Extended for Two Years # Business Financing Kinks # Since You Asked... # Tax Calendar # Plan Now for 2010 Roth Conversions # New Rules for the Domestic Production Deduction # Small Business Expensing Extended Dear Client: We hope that you have maximized your tax savings this season.This newsletter edition offers many topics of interest and includes important changes brought about by the new tax legislation passed in May. One significant change has to do with the domestic production deduction. In an effort to simplify this deduction, Congress included new provisions and the IRS issued final regulations and procedures for the deduction. Under the newly-enacted legislation, the income and marital status restrictions that limit the ability of a taxpayer to convert a traditional IRA to a Roth IRA have been removed.This newsletter discusses some interesting and advantageous tax and estate planning strategies that may now be available to you. The capital gains rates have also been extended by Congress through 2010, and the “zero” tax rates now apply to three years rather than only one. In addition, the increased amounts of the popular small business expensing provisions have been extended. Due to the extension, the expense limit will remain above $100,000 through the 2009 tax year. Most of the topics discussed in this newsletter are just a brief overview. For more information on the new legislation and to determine if any of these changes will affect you, please call our office for an appointment.We are here to help you with your individual needs. B eginning in 2010, under the newly-enacted legislation, the income and marital status restrictions that currently limit a taxpayer’s ability to convert a traditional IRA to a Roth IRA will be removed, leading to some interesting and very advantageous tax and estate planning strategies. Under prior law, an individual was allowed to convert a traditional IRA into a Roth IRA if the taxpayer’s adjusted gross income (AGI) for the year (without the income from the converted IRA) was $100,000 or less. The $100,000 limit is figured without regard to the required minimum distributions from an IRA. Although the income is taxable, the 10% early withdrawal penalty does not apply. Beginning in 2010, the new legislation: (1) Eliminates the $100,000 modified AGI limit on conversions of traditional IRAs to Roth IRAs, and (2) Permits married taxpayers filing a separate return to convert amounts in a traditional IRA into a Roth IRA. Under prior law, married taxpayers who filed separate returns were restricted from making such conversions. Special 2010 Income Inclusion Rule – For conversions made in 2010, a taxpayer can choose to: • Include the income in the 2010 return, or • Include one-half of the conversion income in 2011 and one-half in 2012. Note: 2010 is the last year for the current “low” tax rates unless Congress extends them in future legislation. Income from conversions made in a year after 2010 will be taxable in the year of the conversion. There are also a number of special rules regarding early distributions with respect to conversions. Looking Ahead – There are some interesting strategies a taxpayer can employ to convert nondeductible traditional IRA contributions to a Roth IRA, thereby funding the more favorable Roth IRA. Strategy – Taxpayers who have employer plans and are restricted from making deductible traditional IRA contributions because of income level can make nondeductible traditional IRA contributions in the four tax years leading up to 2010 and then convert those nondeductible traditional IRAs to Roth IRAs with virtually no tax since they were nondeductible. Only the earnings will be taxable. Taxpayers who are prohibited from making Roth IRA contributions because their income exceeds the limit may also benefit from this strategy. (Continued inside) TAX&BUSINESS STRATEGIES New Rules for the Domestic Production Deduction Small Business Expensing Extended T he purpose of the domestic production deduction is to encourage domestic (i.e., within the U.S.) manufacturing and other production activities. The tax incentive is in the form of a tax deduction equal to 3% of the net income from eligible activities. The deduction percentage increases to 6% for 2007 through 2009 and then jumps to 9% after 2009. As with all tax incentives, it comes with a number of complicated limitations and qualifications. In an effort to simplify this deduction, Congress included new provisions and the IRS issued final regulations and procedures for the deduction. R ecent tax legislation has extended the increased amounts of the popular small business expensing provisions, sometimes referred to as Sec. 179 expensing. With the extension, the expense limit will remain above $100,000 through the 2009 tax year. It was previously scheduled to revert to $25,000 in 2008. These extended provisions generally allow small businesses to write off the cost of equipment purchased for use by the business as opposed to depreciating it over several years. For 2006, the inflation-adjusted maximum deduction is $108,000. Although not normally an issue for small businesses, the annual expense limit is phased out when a taxpayer places more than $430,000 (for 2006) worth of expensing-eligible property into service during the tax year. In addition, off-the-shelf computer software will continue to qualify for the expensing deduction, and the taxpayer will have the right to amend or revoke the expensing deduction through the 2009 tax year. If your business was accelerating a purchase to take advantage of this deduction before 2008 to avoid the previously scheduled reduction, you now have an additional two years in which to plan your purchase. An advantage of the Sec.179 expensing deduction is that it is treated the same for both the regular tax and the alternative minimum tax (AMT), so using it will not cause or increase the AMT. Please call this office if we can be of assistance in planning your business expansion and equipment purchases to maximize your tax benefits. What is a qualified production activity? This is the most complicated part. The following are some common eligible activities: (1) the sale or rental of tangible personal property, including computer software that has been manufactured, produced, or grown in the U.S.; (2) the construction of real property in the U.S.; and (3) the performance of engineering or architectural services in the U.S. in connection with real property construction projects in the U.S. Qualified production activities do not include purely sales activities or purely service activities except for construction, engineering and architectural services. Deduction limitations – The deduction cannot exceed 50% of the “W-2” wages paid to employees during the year, and it cannot exceed the taxpayer’s taxable income for the year. An individual’s deduction is limited to the modified adjusted gross income rather than the taxable income. In a recently-passed tax law change, the “W-2” wages for purposes of this limitation are limited to wages properly allocated to the qualified production activity. Who receives this deduction? Generally, the deduction is allowed to all taxpayers, including individuals, corporations, farm cooperatives, estates and trusts. The deduction is passed through to owners of partnerships, S-corporations and cooperatives, allowing them to deduct it on their own returns. Prior law included a special limitation for a partnership or S-corporation owner, which has been removed by the recent new tax law. Example of how the deduction is determined – ABC, Inc. produces widgets in the U.S. that it wholesales to other retailers. The company’s revenue from the sale of the widgets is $2 million with a manufacturing cost of $750,000. ABC, Inc. also has $1 million of income from widget repair services. The total “W-2” wages for the year was $400,000 of which $150,000 was properly allocated to the widget manufacturing costs and the balance used to provide the repair services. The deduction would be determined as follows: Qualified Production Activity Income (widget sales) $2,000,000 Cost of Manufacturing the Widgets Sold Net Income 3% of the Net Income Wages Attributable to the Widget Production 50% of Wage Limitation Domestic Production Deduction (lesser of the two) $150,000 $75,000 $37,500 <$750,000> $1,250,000 $ 37,500 Are You Making Free Government Loans? id you receive a substantial refund from your 2005 taxes? If you did, you are one of a large number of taxpayers who are giving Uncle Sam interest-free loans. Granted, interest rates have been pretty low for the past few years, but they are gradually increasing, so you might want to consider reducing your withholding to the point that it more closely approximates your anticipated tax liability. Some taxpayers use excess withholding as a forced means of saving for other annual expenses, such as property taxes and vacations. The same result could be accomplished by turning the excess withholding into automatic withdrawals for credit union or bank deposits where the interest earnings will go into your pocket, not to the government. The larger the refund, the bigger an issue this becomes. D If you are concerned that you might end up owing a little tax and Uncle Sam might hit you with an underpayment penalty, keep in mind that there are safe harbor amounts that can be used to avoid penalties even if you owe a substantial amount. To avoid possible underpayment penalties, a taxpayer is required to deposit by payroll withholding or estimated tax payments an amount equal to the lesser of: 1) 90% of the current year’s tax liability, OR 2) One of the following amounts: Of course, the deduction on ABC Inc.’s tax return will be limited to the company’s taxable income. This example is a rather simplistic illustration of how the deduction is determined. In actual practice, inventory, the cost of goods, the determination of qualified production wages, etc., all have rules, procedures and complications of their own. However, the deduction can be very beneficial and well worth the added accounting. In fact, most taxpayers who qualify for the deduction are required to claim it, even if the administrative costs of applying the law and regulations outweigh the benefit of claiming the deduction. If you have questions regarding this deduction or need assistance in setting up your accounting to facilitate the deduction, please call this office. a. If the taxpayer’s AGI exceeds $150,000*, 110% of the prior year’s tax liability. b. Otherwise, 100% of the prior year’s tax liability. *$75,000 for taxpayers filing married separate. Do you need help adjusting your withholding amount or are you concerned that you might be subject to an underpayment penalty for 2006? Please call our office so we can assist you with your needs. Plan Now for 2010 Roth Conversions (Continued) Strategy – Using the same strategy, even a taxpayer who can make a deductible contribution can elect to make it nondeductible, resulting in the same outcome as above. Strategy – Generally, rollovers are thought of as transfers from a qualified plan to an IRA or from one IRA to another IRA. However, beginning in 2002, the law has allowed an IRA to be rolled over (or transferred) to other qualified plans including 401(k) plans, 403(a) and 403(b) annuities and 457 governmental retirement plans (assuming the plan will accept the IRA funds). In addition, the law only allows the taxable portion of the IRA to be moved to qualified plans. For taxpayers who have mixed IRAs (including both deductible and nondeductible contributions), this provides a means of segregating the taxable and nontaxable amounts and then later converting the nontaxable portion without paying any conversion tax (except on any interim earnings). Thus, the taxable portion can be rolled over into a qualified plan, leaving the nontaxable portion in the IRA where it can be converted to a Roth IRA. Strategy – More aggressive taxpayers with the financial resources to pay the rollover tax might also consider rolling over (or transferring) the funds from a qualified plan into a traditional IRA and then converting the traditional IRA to a Roth IRA. Minimizing the conversion tax requires careful planning and strict adherence to the conversion rules. If you wish to develop a plan employing one or more of the above strategies customized for your unique tax circumstances, please give us a call. Business Financing Kinks F inancing is often an issue of concern when starting a new business or expanding an existing one. A good place to start is with the Small Business Administration (SBA). However, many entrepreneurs prefer to use the equity in their homes, which will probably provide a lower interest rate and a longer payback period. If you are considering such a move, be aware that there are complications when you borrow against your home and use the funds for business. The interest paid on home mortgages that are secured by the taxpayer’s home is by definition home mortgage interest and, as such, can only be deducted as home mortgage interest. In addition, home mortgage interest cannot be allocated to other uses to the extent it is allowable, either as interest on acquisition debt or as the first $100,000 of equity debt interest. Excess debt interest (interest on debt that exceeds the deductible debt limits) can be allocated to other uses under the general tracing rules. Capital Gains & Dividends Bargain Extended for Two Years Set to expire after 2008, the capital gains rates have been extended by Congress through 2010. In addition, the “zero” tax rates now apply to three years rather than only one. As part of a 2003 tax package, Congress reduced the preferential tax rates on capital gains from 10% and 20% to 5% and 15% respectively, with the lower rates applying to taxpayers in the 15% and under tax brackets. The 5% rate will drop to 0% in 2008, which will be the last year for the temporarily reduced rates. These lower rates apply to both the regular tax and alternative minimum tax (the AMT). Under the TIPRA legislation, these rates were extended through 2010. Tax Bracket 0 – 15% 25% and Above Why is that a problem? There are two reasons: (1) you can only deduct home mortgage interest if you itemize your deductions, so if you deduct the standard allowance, you receive no benefit for the business interest; and (2) interest deducted on your business schedule offsets both income and self-employment tax – not to mention other tax benefits if you are unfortunate enough to have a loss, but mortgage interest deducted on Schedule A is not allowed as a deduction in computing the self-employment tax. What is the solution? If you have already exceeded your home mortgage debt limits, you can go ahead and take more equity out and allocate the interest to your business. If not, you can utilize the “unsecured election,” which allows taxpayers to treat the loan as unsecured, and then use the general tax tracing rules and allocate the business portion of the interest back to your business. There is one pitfall to this election. If the loan is mixed-use (part home and part business), then the home portion of the interest can no longer be deducted as home mortgage interest, since by definition a home mortgage must be secured by the home. A solution to that would be to take a separate loan on the home for the business debt, even though the interest rate might be slightly higher. If you are in need of business capital and are considering refinancing your home, please call our office for assistance. We will gladly address all of your concerns. Capital Gains Rates 2006 – 2007 2008 – 2010 5% 15% 0% 15% Capital gains rates apply to profits from the sale or exchange of capital assets held longer than one year or that have been inherited. Capital assets include corporate stocks, bonds, unimproved real property, rental property and taxable gain from the sale of a home. They don’t apply to the portion of gain attributable to depreciation, which is generally taxed at a higher rate. “Zero” Tax Rate Extended – Under the prior legislation, the “zero” percentage rate only applied to 2008. By merely extending the sunset date of the prior act, Congress is effectively allowing the “zero” rate for three years, 2008 through 2010. Qualified Dividends Extended – The legislation also includes a provision that taxes qualified dividends at capital gains rates through 2010. Under prior law, qualified dividends were only scheduled to receive this special treatment through 2008. TAX CALENDARSEPTEMBER - DECEMBER 2006 SEPTEMBER 15: - Third installment of 2006 Individual Estimated Taxes due. OCTOBER 16: - This is the FINAL extended filing due date for your 2005 individual income tax return. Generally, this filing date is October 15, but when the due date falls on a Saturday, Sunday or holiday, it is not due until the next business day. SEPTEMBER - DECEMBER: - Time for 2006 Year-End and 2007 Tax Planning. Contact this office to schedule a consultation appointment. - Taxpayers who began their minimum IRA distributions before 2006 must withdraw their 2006 distribution by December 31st. The purpose of this newsletter is to provide current information on tax, financial and business developments. It suggests general only be appropriate when claiming tax benefits in a manner consistent with the statutes and Congre tax planning ideas that may ssional purpose. The information and opinions are generalizations and may not apply to all taxpayers and cannot be used by a taxpayer for the purpose may be imposed on the taxpayer. Therefore, it is important that you seek appropriate advice before implementing any nalties that of avoiding pe of the ideas suggested. TAX &BUSINESS STRATEGIES SINCE YOUASKED... YOU ASKED: I am considering taking a job in a foreign country. My potential employer informed me that I could exclude up to $80,000 of income from my U.S. taxes. Is that true? ANSWER: It is partially true, but a little more complicated than that. We also had a change in legislation that takes effect in 2006. The $80,000 your employer mentioned is inflation-adjusted and will be $82,400 for 2006. However, this only applies to earned income from employment in the foreign country, and any other income would still be taxable. In addition, the $82,400 exclusion is for a full tax year in the foreign country, and there are residency qualifications that must be met before you can take the exclusion. You must be in the foreign country for at least 330 days before you are qualified to take the exclusion. For periods of less than a full tax year, the exclusion is prorated by the day. In addition to the earned income exclusion, there is also a foreign housing allowance. New for 2006 is a punitive provision that requires your “other income ” to be taxed at higher marginal tax rates, as if you had not excluded the foreign income and allowable housing allowance. YOU ASKED: I provide considerable support for both of my parents, but I am just short of providing over half the income. From what I read, you must contribute over half the income to receive any tax benefit. Am I out of luck? ANSWER: Where a single taxpayer is helping to support both parents and is having difficulty showing over half of the support for both, it may be appropriate for the taxpayer to designate the support to only one of the parents. This will overcome the 50% dependency support requirement for one of them and may allow you to qualify as head of household if you are single. However, you must be able to provide proof that the support is for one parent only. Otherwise, the support will be designated as a “fund ” equally allocated to both. The IRS suggests a notation on a check as an acceptable designation procedure.