Unfortunately, since December 31 coincides with the tax-reporting period for 99 percent of U.S. individual taxpayers, the average taxpayer will only begin thinking about their 2007 taxes during the first quarter of 2008. Unfortunately, this delay is generally very costly, since almost every individual taxpayer reports taxable income on a cash basis, as opposed to an accrual basis.
In order to minimize tax liabilities, it is necessary to pay certain expenses before year-end in order to claim them as tax deductions. It is also important for taxpayers to determine if they are in an alternative minimum tax position, which can change the entire year-end tax-planning strategy.
The following are the more common year-end planning areas for taxpayers to consider:
1. Defer Taxable Income
* Postpone receipt of year-end bonuses until January 2008. Also, consider accepting “restricted property” (e.g., restricted stock, unvested automobile, computer, etc.) in lieu of cash compensation in order to defer income reporting.
* Elect the “installment” reporting method to spread out income for disposition of certain assets.
* Defer the sale of appreciated investments until January 2008.
* Delay qualified plan (e.g. IRA/401(k)) distributions and/or elect a method to minimize required distributions.
* Utilize various “rollover” provisions (e.g., IRA-to-IRA transfers, Section 1031 like-kind exchanges, Section 1034 for insurance products, corporate reorganizations, etc.).
* Utilize charitable remainder trusts to diversify holdings in appreciated investments, or donate appreciated stock to a charity in lieu of selling and giving the charity cash.
* Delay exercising stock options until January – especially if they are non-qualified stock options, which trigger income upon exercise. Note that the exercise of incentive stock options does not trigger taxable income for “regular” tax purposes. The spread between the “strike price” and the fair market value on the date of exercise triggers additional AMT income.
2. Accelerate Losses and Deductions
* Sell off devalued investments. Up to $3,000 of net capital losses can offset ordinary income. Additional losses can offset capital gain income.
* Dispose of “passive activity” investments (e.g., rental property, partnership interest, etc.) with loss carryovers in order to accelerate utilization.
* Make sure there is sufficient tax basis in an S corporation, partnership or LLC in order to claim the entire tax loss generated (or absorb 2007 distributions) during the year.
* Sell, donate or otherwise dispose of devalued business assets, including inventory.
* Consider “bunching” certain expenses, such as un-reimbursed medical costs, or un-reimbursed employee business expenses, which must reach 7.5 percent or 2 percent, respectively, of adjusted gross income before generating a tax benefit.
* Consider pre-paying a second installment of property tax, a January mortgage payment and/or a state income tax balance due, provided they are not expected to be subject to the alternative minimum tax.
* Tax deductions can be accelerated into 2007 by paying them via check or credit card by year-end.
3. New-for-2007 Federal Opportunities (and Pitfalls)
Kiddie Tax: For 2007, a child under the age of 18 is subject to the “kiddie tax” (and thus pays tax at his or her parents’ highest marginal tax rate on unearned income in excess of $1,700). But in 2008, the applicable age rises to 19 and full-time students under the age of 24.
Tax breaks set to expire at the end of 2007 include the following:
* State and local sales tax deduction. The American Jobs Creation Act of 2004 gave taxpayers who itemize deductions the option of claiming either: i) state and local income taxes or ii) state and local general sales taxes. Therefore, if taxpayers expect their state income tax to be relatively small for 2007, they might consider accelerating large purchases into 2007.
* Mortgage insurance premiums. Premiums paid or accrued in 2007 for qualified mortgage insurance are deductible as qualified residence interest.
* Tuition and fees deduction. Taxpayers may deduct qualifying tuition and fees paid in 2007 that are required for the student’s enrollment or attendance at a post-secondary school. The tuition and fees deduction can reduce the amount of a taxpayer’s income subject to tax by up to $4,000 if their modified adjusted gross income does not exceed $65,000 (single taxpayers) or $130,000 (married filing jointly). No deduction is available for taxpayers with incomes higher than these amounts.
* Educator deduction. Most teachers, instructors, counselors and other educators can deduct up to $250 worth of books, supplies, software and other qualifying expenses. The deduction is set to expire at the end of 2007, unless Congress extends it.
* Residential energy credits. Homeowners may be eligible to claim a credit of up to $500 for the costs of making certain energy-efficient improvements to their principal residence, if the improvements are made before 2008.
Cash donations. Starting in 2007, cash donations of any size must be substantiated by paperwork that includes either a cancelled check or a written note from the charity indicating the amount, date and name of the charity.
4. California State Enterprise Zone and Federal Tax Credit Programs.
If a business is located in any one of the 42 state enterprise zones throughout the state (including significant portions of Downtown Los Angeles, Hollywood, Santa Clarita, Compton, San Pedro, Wilmington, Long Beach, Santa Ana and San Diego) or one of the federal empowerment or renewal zones (limited portions of Los Angeles, Santa Ana and San Diego), the business may be entitled to claim hiring credits for employees for up to the past four years, and future years ranging from $1,500 to $11,700 per qualified employee. Additional benefits, including equipment credits, financing benefits and gain exclusion, are also available. There are 40 other states with tax incentive programs.
5. AMT Tax.
Many taxpayers with large itemized deductions relative to their gross income, or a large percentage of their income coming in the form of capital gains income, will find themselves subject to the AMT system of reporting 2007 tax liabilities. This system is reported on the normal tax filings, but an additional form (IRS Form 6251) is required. While the top tax AMT rate is 28 percent vs. the maximum “regular” tax rate of 35 percent, the AMT tax rates are applied to a much broader tax base (more income items and fewer deductions). Since certain deductions such as state income tax and home equity lines are not deductible for AMT purposes, taxpayers must carefully decide whether to accelerate such payments before year-end.
6. Planning starts now.
Effective tax planning involves advanced preparation and a thorough analysis of all factors. Taxpayers should not wait until the last minute to look at their tax situations. The time to start planning for year-end is now.
Blake Christian is a tax partner in the Long Beach office of HCVT LLP, a CPA firm headquartered in Southern California.
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