by George G. Jones and Mark A. Luscombe
Year-end tax planning season is suddenly upon us. For most individuals, this means last-chance opportunities to balance income and deductions advantageously between the current and the upcoming year.
It also means skillfully working the new opportunities - and avoiding the new pitfalls - presented by recent legislation and Internal Revenue Service rules. The 2003 year-end tax season is no exception, especially in the latter categories.
The Jobs and Growth Tax Relief Reconciliation Act of 2003, in particular, has lowered the bar on the client profile needed to warrant professionally guided year-end planning.
Most investors, even those with modest portfolios, will need a new roadmap for balancing capital gains and losses. Small business owners require special guidance on planning purchases of capital assets. Teachers and executives, too, as well as people with substantial medical expenses, also need special assistance this year.
With those taxpayer profiles in mind, here are some factors to consider for the 2003 year-end tax planning season.
More complicated capital gains netting
Converting ordinary income into capital gain has a higher payback now than prior to the general rate reduction made by the JGTRRA. The difference between the maximum tax on net capital gains of 15 percent and the highest income tax bracket of 35 percent is 20 percentage points or, more dramatically stated, 133 percent. Prior to the JGTRRA, the difference was 18.6 percentage points.
More important, however, is the increase in the difference for the ordinary client - those in the 25 to 33 percent brackets; a drop from a 20 percent to a 15 percent capital gains rate makes a significant difference to those individuals.
In looking at a taxpayer’s optimum net capital gains or losses for the year, 2003 is especially challenging.
There are many more variables to consider during this “transition” year, in which some capital gains are taxed under the 20 percent rate, some under the new 15 percent rate, and some together with qualified dividends, but for gain purposes only. The new Form 1040 Schedule D provides the roadmap for computing net capital gains and losses this year.
Within that scheme, here are a few points to remember:
● The 28 percent rate imposed on long-term gain from collectibles and net gain from small business stock, as well as the 25 percent rate imposed on unrecaptured Code Sec. 1250 gain, remain unchanged.
● Selling a long-term capital asset after May 5 may result in more tax being paid if the benefit of the 8 percent rate on five-year property is lost on that sale.
● Pre-May 6 net long-term capital losses may offset the amount of capital gains that are taxed at the new lower rate. As a result, taxpayers might consider postponing long-term capital gains sufficiently to be able to offset $3,000 of losses against ordinary income for 2003.
● Qualified dividend income received in tax years beginning after Dec. 31, 2002, qualifies for a maximum capital gains rate of 15 percent. In fact, it is added to net capital gains for purposes of applying the 15 percent rate. Under the 2003 transitional computation, qualified dividend income is treated as though it was taken into account by the individual on or after May 6, 2003.
● Dividend income for fiscal year taxpayers ending in 2003 will not be entitled to the 15 percent rate, but will be taxed as ordinary income.
Increased Code Sec. 179 expensing limits
Effective retroactively to Jan. 1, 2003, the size of available Section 179 expensing has quadrupled to $100,000 annually, with double the ceiling on the amount of qualifying assets that may be purchased before the phase-out of the deduction begins. Some points to consider here are:
● The higher expensing limit applies only for 2003 through 2005. It is then scheduled to return to its pre-JGTRRA level of $25,000.
● The new $100,000 ceiling may be much more than a small business can project spending over the course of several years. Those taxpayers may safely defer purchases into 2004 or 2005.
● Assets purchased at year’s end receive the same expensing deduction as those purchased at other times during the year. There is no pro-ration or half-year conventions applied, making a strong case for accelerating some early 2004 purchases into December 2003.
● Generally, selecting assets with longer depreciable lives for expensing and choosing to depreciate other capital purchases is good planning. This decision does not need to be made until the return is filed, allowing for some post-year-end second-guessing.
● The operation of the maximum Section 179 asset purchases during a year is non-elective. If more than $400,000 in qualified property is purchased in 2003 ($410,000 in 2004, as adjusted for inflation), a dollar-for-dollar phase-out takes place and must be applied. Spreading out purchases between 2003 and 2004 may be in order if that limit is in danger of being surpassed.
● Raising the expensing limit to $100,000 ($102,000 in 2004, as adjusted for inflation) eliminates the need for many taxpayers to argue that an expense should qualify as an immediate Section 162 business expense deduction rather than be capitalized, since, if it must be capitalized, it may be expensed in its first year anyway.
For taxpayers in danger of breaking the $400,000 annual ceiling, however, guessing incorrectly on how the IRS will treat the expense on an audit may prove costly.
Bonus depreciation
The Job Creation and Worker Assistance Act of 2002 created a 30 percent additional first-year depreciation allowance for qualifying MACRS property. The property generally must be acquired after Sept. 10, 2001, and before Sept. 11, 2004, and placed in service before Jan. 1, 2005. JGTRRA increases the additional first-year depreciation allowance percentage from 30 percent to 50 percent.
To qualify for the higher percentage, the property must be acquired after May 5, 2003, and placed in service before Jan. 1, 2005.
There is no dollar cap on the amount of bonus depreciation that a taxpayer may take each year. Taxpayers, therefore, can defer purchases into 2004 and not lose out on any part of this deduction.
However, if the property also qualifies as Section 179 property (bonus property must be new, while Section 179 may also be “original use”), deferring all purchases until 2004 for bonus depreciation purposes may have the effect of bunching purchases for purposes of the $410,000 ceiling on Section 179 property before the Section 179 expense cap of $102,000 is phased out.
The election out of either 50 percent bonus depreciation or bonus depreciation entirely is made separately for each class of property that qualifies for the 30 percent rate and for each class of property that qualifies for the 50 percent rate.
For example, a taxpayer may elect out of bonus depreciation with respect to one class of property that qualifies for 30 percent bonus depreciation, but decide not to elect out of bonus depreciation for property in the same class that qualifies for bonus depreciation at the 50-percent rate. Although the election may be made after Dec. 31, 2003, purchases should be considered accordingly before year’s end.
Another deadline
The IRS recently granted taxpayers additional time for electing to claim bonus depreciation in a tax year that includes Sept. 11, 2001. In addition, the revised rules allow qualifying taxpayers the opportunity to reallocate their original Code Sec. 179 expense allowance for that tax year.
Several factors go into a decision whether to use this new grace period, and then how to implement it. After Dec. 31, 2003, a qualifying taxpayer will need to file Form 3115 in order to take advantage of the time extension to make the election.
However, this post-2003 option is only available if the taxpayer’s return for the first tax year succeeding the tax year that included Sept. 11, 2001 (for example, the 2002 return for a calendar-year taxpayer), was filed on or before July 21, 2003.
Thus, if a calendar-year individual obtains a four-month extension to file her 2002 return, the option is not available if the return was filed after July 21, 2003.
The AMT trap
Although the JGTRRA included several provisions that slow the growing trend for many more taxpayers to be subject to the alternative minimum tax, the danger still exists for many taxpayers. Lower marginal rates increase the risk of AMT exposure. Higher exemption limits and allowing lower capital gains rates for the AMT reduce AMT exposure.
Perhaps ironically, however, increasing capital gains due to the lower rates for regular and AMT purposes may increase a taxpayer’s state income tax deduction and, therefore, expose him to an increased risk of AMT exposure.
Expiring teacher’s deduction
A teacher may deduct up to $250 of qualified out-of-pocket classroom expenses above the line for 2003. However, it is not available in 2004, so year-end planning is essential to take advantage of this expiring provision. Expenses qualifying for the deduction include books; supplies, such as glue, paper, pens and scissors; and computer equipment and software. Athletic equipment is generally ineligible.
Expenses must be out of pocket. If the taxpayer is reimbursed by the school, the expenses are ineligible for the deduction. If the school partially reimburses the taxpayer, the unreimbursed portion may qualify for the deduction. To be eligible for the deduction, an individual must work at least 900 hours during the school year.
Broadening of allowable medical expense
This year has brought new flexibility, and some confusion, as to what qualifies as a medical expense. For deduction purposes, and under tax-free medical plan coverage, rulings over the past several years have allowed laser eye surgery, weight-loss programs for the obese, and stop-smoking programs as proper medical expenses.
Year-end confusion, however, is likely to develop at the client level due to misinformation given in some popular press reports of the IRS’s acceptance that over-the-counter drugs are properly reimbursable by medical flexible spending accounts.
First, this leniency does not apply to the medical expense itemized deduction. In addition, employer flexible spending account reimbursement policies must be amended before they are able to reimburse for over-the-counter drugs using pre-tax contributions.
New split-dollar regs
Split-dollar plans have come under heavy fire in recent years from the Treasury Department and the IRS. Split-dollar use in executive compensation packages attracted the attention of the IRS for possible tax avoidance.
The IRS recently issued new regulations on the tax treatment of split-dollar insurance arrangements. New split-dollar arrangements - created on or after Sept. 17, 2003 - are subject to the new rules.
However, for split-dollar life insurance arrangements created before Sept. 17, 2003, taxpayers can rely on the old rules under Notice 2002-8 - but only if the arrangement is not “materially modified” after that date. It will make sense for some taxpayers under this guidance to terminate split-dollar arrangements or convert to a loan by Dec. 31, 2003.
George G. Jones, J.D., LL.M., is the managing editor of Federal and State Tax, and Mark A. Luscombe, J.D., LL.M., CPA, is the principal analyst of Federal and State Tax, at CCH Inc., Riverwoods, Ill.
