Tax planning to infinity and beyond…
Another year has come and gone and what’s really changed? Are you sitting in roughly the same place you were last year at this time with respect to your taxes–wondering what you could have done differently in your business to positively affect your year- end tax bill?
All too often, when individuals and closely-held business owners begin discussing tax planning, what they really end up referring to is the process of tax compliance. Tax compliance is the process of reporting your income to the Internal Revenue Service and, hopefully, accurately ensuring that your tax preparer takes advantage of all the deductions and credits you are entitled to. Often by this time, however, it’s really too late to do any real tax planning. Having stated that, the accurate and timely preparation of your tax returns are obviously a crucial step in realizing the effect of this year’s tax planning (or lack thereof ), and there are still things you can do, even at this late stage, to help reduce your current and future income tax bite.
Avoiding Common Pitfalls Because the effects of good tax planning can obviously be forgone without proper reporting and compliance, it is extremely important to make sure that you are working with a competent tax professional on your tax preparation. Because this is what tax preparers live for, and it is their specialty to make sure that you take advantage of all that the tax code affords you as a taxpayer, it is often well worth the additional investment in time and money to work with a competent tax preparer that has a good grasp of your business. Very often, a good tax preparer will earn their fee by recognizing additional tax savings through credits or deductions the taxpayer may have overlooked, or through the timely and accurate preparation of your tax return, which, at a minimum, can avoid the costly penalties and interest that come with late or inaccurate filings. Additionally, it is important to keep in mind that the cost of tax preparation is fully tax deductible for your business. For individuals, the fees are also deductible, although this a miscellaneous itemized deduction and in this case, the total of all miscellaneous itemized deductions must exceed 2 percent of your adjusted gross income before you can begin realizing any benefit.
Whichever way you decide to go, with or without a professional tax preparer, it is important to not overlook some of the common tax preparation mistakes that befall many taxpayers. Here are a few of the most common pitfalls to avoid, as well as a few of the most commonly missed deductions:
Forgetting to sign your return or attach all required documentation and schedules.
Carryover items – Don’t forget about charitable contributions, capital losses or net operating losses that are being carried forward from a prior year. It can be easy to overlook these items so be sure to refresh your memory by reviewing last year’s return. This type of review may also help ensure you don’t overlook other items of income or deduction that appeared on your previous returns.
Disallowed Roth IRA contributions – If you are planning to contribute to a Roth IRA, make sure you are below the income limitations for such contributions. If you are a single taxpayer who’s modified adjusted gross income is in excess of $110,000 (or in excess of $160,000 for married couples filing a joint return), you are not permitted to contribute to a Roth IRA and doing so will subject you to a 6 percent penalty on the contribution amount. If you have made this mistake, however, there is still time to correct the problem, provided you withdraw the excess contribution prior to April 17, 2006, for 2005 contributions.
Recent changes in marital status – If you are recently married or divorced, you should make sure that the name on your tax return matches the name registered with the Social Security Administration (SSA). Any mismatch can cause significant delays in processing your return and can inadvertently affect the size of your tax bill or refund amount. Name changes can be easily reported to the SSA by filing a form SS-5 at your local SSA office. Keep in mind, your marital status as of December 31st will also control whether you may file as single, married or head of household.
Education tax credits and student loan interest – Interest paid on student loans can be deducted on your personal tax return, even if you do not itemize your deductions. If you or your dependent is attending college with the intent of earning a degree or certificate, you may qualify for the Hope or Lifetime Learning Credits, which can reduce your tax by as much as $2,000 for 2005.
Business start-up expenses – The expenses a business owner incurs before he opens his doors for business can be capitalized and written-off by the owner over a 5-year period. Due to a change in the tax law in 2004, up to $5,000 of start-up expenditures can now be currently deducted.
Professional fees – The expenses paid for attorneys, tax professionals and consultants are generally deductible in the year they are incurred. In certain circumstances, however, the costs can be capitalized and deducted in future years. In other words, the cost of your tax preparation or legal advice is considered an ordinary and necessary business expense and you may offset this cost against your income. Therefore, this deduction has the effect of reducing the effective cost of these services, thereby making those professional services a little more affordable.
Auto expenses – If you use your car for business, or your business owns the vehicle, you can deduct a portion of the expenses related to driving and maintaining it. Essentially you may either deduct the actual amount of business-related expenses, or you can deduct 40.5 cents per mile driven for business for 2005. This rate was then increased to 48.5 cents per mile after September 1, 2005, due to the spike in gas prices. As noted below, the rate for 2006 has been modified again to 44.5 cents per mile. You must document the business use of your vehicle regardless if you use actual expenses or the mileage rate.
Education expenses – As long as the education is related to your current business, trade or occupation, and the expense is incurred to maintain or improve your skills in your present employment; or is required by your employer; or is a legal requirement of your job, the expense is deductible. The cost of education to qualify you for a new job, however, is not deductible.
Business gifts – Deductions for business gifts may be taken, provided they do not exceed $25 per recipient, per year.
Business entertainment expenses – If you pick up the tab for entertaining current or prospective customers, 50 percent of the expense is deductible against your business income provided the expense is either “directly related” to the business and business is discussed at the entertainment event, or the expense is “associated with” the business, meaning the entertainment takes place immediately before or after the business discussion.
New equipment depreciation – The normal tax treatment associated with the cost of new assets is that the cost should be capitalized and written-off over the life of the asset. For new asset purchases, however, Section 179 of the Internal Revenue Code allows taxpayers the option in the year of purchase to write-off up to $105,000 of the asset cost in 2005 ($108,000 in 2006).The limits on these deductions begin to phase out, however, if more than $430,000 of assets have been placed in service during the year.
Moving expenses – If you move because of your business or job, you may be able to deduct certain moving expenses that would otherwise be non-deductible as personal living expenses. In order to qualify for a moving expense deduction, you must have moved in connection with the business (or your job if you’re an employee of someone else), and the new workplace must be at least 50 miles further from your old residence than your old workplace was.
Advertising costs – The cost of advertising for your goods and/or services is deductible as a current expense. Examples may include business cards, promotional materials that create business goodwill, or even the sponsoring of a local Little League baseball team, provided there is a clear connection between the sponsorship and your business (such as the business name being part of the team name or appearing on the uniforms).
Software – Generally speaking, software purchased in connection with your business must be amortized over a 36-month period. If the software has a useful life of less than one year, however, it may be fully deducted in the year of purchase. Also, under Section 179 (as noted above), computer software may now be fully deducted in the year of purchase. Previously, computer software did not qualify for Section 179 treatment.
Taxes – In general, taxes incurred in the operation of your business are tax deductible. How and where these taxes are deductible depends on the type of tax. For example:
Federal income tax paid on business income is not deductible although state income taxes are deductible on your federal return.
The employer’s portion of Social Security is deductible as a business expense.
Sales taxes paid on items you buy for your business’s day to day operations are deductible as part of the cost of those items. Sales tax on asset purchases that are capitalized will have the sales tax capitalized and deducted over the life of the asset.
Real estate taxes paid on property used in your business is also deductible along with any local special assessments for repairs and maintenance. Assessments paid for improve ments (e.g., adding a sidewalk) is not immediately deductible, but is rather capitalized and deducted over a period of years.
Other expenses to keep in mind may include the cost of audio tapes (videotapes) related to training or business skills; bank charges; business association dues (chamber of commerce); business related periodicals or books; coffee or beverage services; office supplies; postage; seminars; and trade shows, to name a few.
2005 Tax Planning Items As noted above, the real planning for 2005 should have begun with the beginning of the tax year. Nonetheless, although we are already into 2006, there is still time to take advantage of a few tax rules that could have a significant effect on your current 2005 tax bill, and on future tax bills.
IRA Contributions You have until April 17, 2006, to make contributions to your Individual Retirement Account (IRA) for 2005. In fact, you can contribute up to $4,000 and take a deduction from your 2005 income for all of it, provided you did not participate in a company-sponsored retirement plan and provided your income falls below certain statutory levels ($50,000 for single filers and $70,000 for married couples). If you were over the age of 50 by the end of 2005, the limit increases to $4,500. Even when you did participate in a company-sponsored retirement plan, your spouse can generally contribute (and fully deduct) $4,000 to an IRA as long as your combined adjusted income is $150,000 or lower, and your spouse is not a participant in a company sponsored plan. In other words, assuming a 25 percent tax bracket, a married couple could contribute $4,000 each to their own IRAs and reduce their current tax bill by $2,000.
Education Savings There are two primary tax-advantaged ways to save for education. One is a 529 Plan and the other is an Education Savings Account. Although contributions to a 529 Plan had to be made before the year-end, contributions to an Education Savings Account can be made any time until April 17, 2006. An Education Savings Account allows you to invest up to $2,000 per year in a savings account, mutual fund or brokerage account (through which you can invest in individual stocks and bonds). Although this contribution is not tax-deductible for 2005, the money invested will grow tax-free and all withdrawals from the account will be tax-free as well provided the funds are used for qualified education expenses (e.g., tuition, books, etc.). Much like many of the tax benefits available to taxpayers, there is an income limitation that must be met in order to invest tax-free in an Education Savings Account. For joint return filers, this opportunity begins to phase out when their modified adjusted gross income exceeds $190,000. For single filers the phase-out begins at $95,000 of modified adjusted gross income.
What’s new for 2006 With a new year comes new tax laws. Being an educated taxpayer and staying abreast of these changes will help you plan for 2006 and allow you to take advantage of these opportunities. The following items are new to the tax code within the last year.
The Katrina Emergency Relief Act of 2005 and The 2005 Gulf Zone Opportunity Act; The 2005 Katrina Relief Act was signed into law on September 23, 2005, and provides a package of income tax relief provisions to help victims of Hurricane Katrina. The Gulf Zone Opportunity Act of 2005 essentially extended the relief provisions of the Katrina Relief Act to victims of Hurricanes Rita and Wilma as well.
Just a few of the opportunities available under these acts include:
Penalty free withdrawals from qualified plans of up to $100,000 provided the individual making the withdrawal suffered an economic loss because of one of the three hurricanes (Katrina, Rita or Wilma).
Individuals that were eligible for tax relief for hurricane-related distributions may pay the income tax on such distributions ratably over a three year period.
Loan limitations from qualified plans were also increased for hurricane victims by doubling the thresholds to the lesser of $100,000 or 100 percent of the individual’s account balance. Additionally, loans due from hurricane victims to qualified plans can be deferred for an additional 12 months on top of the maximum repayment period.
Non-business casualty losses are generally deductible by taxpayers who itemize their deductions and then only to the extent the casualty loss exceeds 10 percent of adjusted gross income and a $100 floor. These rules were eased by the Act by eliminating the 10 percent rule and the $100 floor for hurricane victims.
Corporate charitable contributions were eased allowing corporations to claim a charitable deduction for cash contributions related to these hurricanes without regard to the 10 percent of taxable income cap.
Additionally, these Acts contain a number of tax incentives to encourage rebuilding of the areas ravaged by these three hurricanes.
If you have been affected by one of the hurricanes noted above, live in one of the hurricane zones or have contributed to relief efforts, you should consult with a professional tax advisor to discuss the full extent of these new provisions.
Other changes for 2006 include:
Adjustment of the standard mileage rate to 44.5 cents per mile.
Increase in the 401(k) contribution limit to $15,000 per year (up from $14,000), as well as an increase in the catch up contribution permitted for taxpayers that are 50 or older to an additional $5,000 (up from $4,000).
The Social Security wage limit has increased from $90,000 in 2005 to $94,200 for 2006. Remember, this wage limitation applies only to the 6.2 percent OASDI component (old age survivors and disability insurance) of social security. The 1.45 percent Medicare component of payroll taxes applies to all wages.
In the estate tax arena, the lifetime estate tax exclusion amount has increased from $1.5 million to $2 million for 2006 through 2008 and the annual gifting limit has increased from $11,000 annually to $12,000 annually. Under current law, the lifetime estate tax exclusion amount is slated for increase again in 2009 to $3.5 million before the repeal of the estate tax for one year in 2010. In 2011, the estate tax system returns with the exemption amount returning to $1 million. This is an important planning consideration; however, most experts in this field believe that more estate tax changes are on the way. As a result, it is likely these rules will all be modified again before the next set of changes come into effect in 2009 and beyond.
The top estate tax rate has also dropped from 47 percent to 46 percent for 2006. This rate is again scheduled to drop one percent to 45 percent in 2007 and that rate will stay in effect until the 2010 repeal. As noted above, however, it is likely the estate tax laws will change by that time.
The gift tax credit remains at $1 million. If you plan on making significant gifts during your lifetime, the difference between the estate tax exclusion and the gift tax exclusion must be noted to ensure that you don’t get a surprise from the IRS.
Tax Planning – Let’s look ahead As previously discussed, the process of tax planning is often confused with tax compliance. Individuals and closely-held business owners that are armed with a good understanding of the tax code can have a tremendous effect on their ultimate year- end tax liability with some good, forward-thinking tax planning. Unfortunately, however, by the time most people usually consider tax planning, they are past the point that they can positively effect a transaction.
Before you enter into any significant business transaction, it would be wise to consult with a competent tax professional to determine whether the transaction is structured properly from a tax perspective. There are often very tax efficient ways to accomplish your business goals; however, without proper planning, the tax opportunities that may otherwise be available in a transaction could vanish forever.
For example, if you are considering selling investment real estate or business property and replacing that real estate with another piece of property, you should be considering handling the transaction as a “like-kind exchange.” The “like-kind exchange” rules under Section 1031 of the Internal Revenue Code allow any gain realized on the sale of the property to be deferred until the subsequent sale of the replacement property. Like-kind exchanges are also appropriate with property other than real estate, provided of course the property is of “like-kind,” the determination of which requires an understanding of the tax rules and the various tax classifications for personal and real property.
Like-kind exchanges are also a perfect example of a planning opportunity that will be unavailable if not properly addressed in advance of the transaction. There are very strict rules regarding the timing of the transaction, when property is identified and purchased, and even very strict rules about how the proceeds from the sale need to be handled in order to preserve the “like-kind” treatment. If these rules are not met, you can not have a “like-kind exchange.”
The “like-kind exchange” example was simply meant to illustrate how important it is to address the tax ramifications in advance of an impending transaction. Always keep your professional advisors in the loop when considering any significant business transaction or your opportunity may be lost, which can have significant costs that perhaps could have been avoided. Remember, good tax planning is not about making sure your tax returns are properly prepared and that you have availed yourself of all the appropriate tax deductions and credits available to you and your business. It is really about structuring your business and your transactions in a way that not only meet your business needs, but do so in the most tax advantaged manner.