As the fall season moves into high gear, a tax practitioner's thoughts should turn, at least in part, to year-end tax planning. Year's end provides a unique opportunity to evaluate how each client's tax liability is shaping up while there is still time to tweak transactions to maximize tax savings between the current and the upcoming year.Many year-end tax planning considerations and techniques should be repeated year after year. Deciding whether to accelerate deductions or defer income, as well as taking the time to consider all deduction opportunities before they slip away with the old year, are "ol' standards" that never change.
Part of year-end planning, however, should be focused on what is changing in the tax law, so certain actions may be postponed or accelerated as a result. This article surveys those tax law changes that have a special impact on 2005 year-end tax planning.
Pease deduction phase-out
Before 2006, higher-income individuals whose adjusted gross income exceeds a threshold level must reduce the amount of their otherwise-allowable itemized deductions. This itemized deduction limitation (the so-called Pease deduction) will be repealed in stages over a five-year period from 2006 through 2009. Under the phase-in of the repeal of the itemized deduction limit for tax years beginning after 2005, the limitation will be reduced by one-third in 2006 and 2007; two-thirds in 2008 and 2009; and is repealed for 2010.
Under the limitation, itemized deductions that would otherwise be allowable are reduced by the lesser of 3 percent of the amount of the taxpayer's AGI in excess of an inflation-adjusted threshold amount (for 2005 it is $145,950 ($72,975 for a married individual filing separately)) or 80 percent of the itemized deductions otherwise allowable for the tax year. For purposes of this limitation, itemized deductions do not include the deduction for medical expenses, investment interest, casualty or theft losses, or allowable wagering losses.
Higher-income individuals who find themselves close to the threshold amounts of AGI in 2005 should consider shifting their deductions to 2006 by deferring payment of deductible expenses if they are on the cash method. They would lose less of the amount of the deductions due to the benefit of reductions in the itemized deduction limitation for 2006.
Katrina relief deadlines
The Katrina Emergency Tax Relief Act of 2005 provides a number of tax benefits that expire at the end of 2005. They include broadening the charitable contribution for food inventory to all business entities; an enhanced book donation deduction for C corps; and a work opportunity credit for employers outside the disaster area that hire displaced workers.
The act also includes the lifting of the contribution base limitation on cash charitable deductions by individuals for the remainder of 2005. However, unlike many of the other relief provisions, this one is not limited to Katrina-directed donations. This presents a unique opportunity for some taxpayers not only to give more generously to Katrina relief efforts, but also to take the opportunity to accelerate their generosity to religious groups, alma maters, local hospitals or any other similar charitable organization before year-end 2005.
Under the new law, individuals are allowed a full deduction for qualified contributions unimpeded by the usual 50 percent contribution base limitation. Contributions in excess of this amount are carried forward for up to five years as usual.
Qualified contributions are defined as cash contributions made during the period beginning on Aug. 28, 2005, and ending on Dec. 31, 2005, to a charitable organization described in Section 170(b)(1)(A) (other than a supporting organization described in section 509(a)(3)).
Such organizations typically include churches, educational institutions, hospitals, governmental units, publicly supported organizations, supporting organizations, common fund foundations, private operating foundations, and conduit foundations. While an enhanced corporate charitable deduction is limited to Katrina-related contributions, no such restriction is placed on contributions from individuals. Qualified contributions also will not be treated as an itemized deduction for purposes of the overall limitation on itemized deductions.
Energy Act credits
The Energy Tax Incentives Act of 2005 provides three consumer-oriented tax credits that should be factored into year-end planning.
A tax credit of up to $500 lifetime over the 2006 and 2007 tax years is available to homeowners for nonbusiness energy property, such as residential exterior doors and windows, insulation, heat pumps, furnaces, central air conditioners and water heaters. Also new is a residential alternative energy credit of 30 percent of the cost of eligible solar water heaters, solar electricity equipment (photovoltaics) and fuel cell plants. The maximum credit is $2,000 per tax year for each category of solar equipment, and $500 for each half kilowatt of capacity of fuel cell plants installed per tax year.
Both of these credits apply only to property "placed in service" after 2005. Existing regulations for depreciation define "placed in service" to mean "the time that property is first placed by the taxpayer in a condition or state of readiness and availability for a specifically assigned function." While actual use is not necessary, property that is substantially ready may be considered placed in service at that time. Those who choose to slow down the installation process of energy property to qualify for an energy credit in 2006 should document the installation process.
Also effective Jan. 1, 2006, the 2005 Energy Act eliminates the clean-fuel vehicle deduction, replacing it with a more generous credit. Most individual taxpayers who purchase qualifying hybrid vehicles will be allowed around a $2,000 credit based on a sliding scale for efficiency. The provision is effective for vehicles placed in service after Dec. 31, 2005. For year-end planning purposes, this date is measured by when the taxpayer takes possession of the vehicle and registers it for road use.
FSA 'use-it-or-lose-it' rule
The IRS has relaxed the "use-it-or-lose-it" rule for flexible spending accounts. Under Notice 2005-42, employers can give employees an additional 2.5-month "grace period" into the next year to use the funds in their FSAs. Before the change, employees had to use all of their FSA dollars by the year's end or forfeit the balance to their employers.
This extended year-end planning benefit, however, is available only if the employer takes the initiative. Employers can adopt a grace period for the current cafeteria plan year, or for future years, by amending their plan documents before the end of the plan year.
Starting in 2006, employees will be able to designate all or part of their contributions to their 401(k) plans on an after-tax basis, which will make most distributions tax free. The Economic Growth and Tax Relief Reconciliation Act of 2001 first authorized these accounts, but delayed their effective date until tax years beginning after Dec. 31, 2005. The IRS is issuing rules now to give employers plenty of time to amend their plans. No plan sponsor is forced to amend its plan, but no employee may elect after-tax Roth contributions without that amendment. Proposed regulations (NPRM REG-152354-04) spell out the requirements.
* Sales tax itemized deduction. For 2004 and 2005, the American Jobs Creation Act of 2004 allows individual taxpayers to elect to deduct either their state and local income taxes or their state and local sales taxes. Only taxpayers who itemize can take the deduction.
While lawmakers from states with no income taxes are lobbying hard to make the optional deduction permanent, no legislation has yet to surface from committee. Taxpayers who are planning to take the deduction in 2005 and not use the standard tables provided by the IRS should consider accelerating some anticipated 2006 purchases into December 2005.
* Higher education expense deduction. Individuals may take an above-the-line deduction for qualified tuition and related expenses in tax years beginning after Dec. 31, 2001, and before Jan. 1, 2006. In 2004 and 2005, the maximum deductible is $4,000 for taxpayers with AGI not exceeding $65,000 ($130,000 for joint filers). Those whose income exceeds that limit but does not exceed $80,000 ($160,000 for joint filers) in 2004 and 2005 may deduct up to $2,000 in qualified expenses.
The deduction is allowed for expenses paid during a tax year, in connection with an academic term beginning during the year or the first three months of the next year. Especially if the individual does not qualify for the Hope or Lifetime Learning credits, arrangements should be made to pay tuition for the spring semester before 2006 in order to qualify for the deduction. If end-year legislation extends this deduction, the taxpayer can always re-evaluate at that time whether to pay in 2005 and 2006.
* Educators' deduction. Teachers should save their receipts for unreimbursed school-related expenses. Eligible teachers and other educators (including instructors, counselors, principals and aides) are entitled to a deduction of up to $250 for qualified expenses on their 2005 return. This deduction is scheduled to sunset at the end of 2005. However, several proposals have been floated in Congress to extend it.
* Higher AMT exemption. No one believes that the present alternative minimum tax exemption amounts won't be extended to 2006, but at press time, legislation had yet to be passed to do so. Without the extension, the Treasury reports that more than two-thirds of taxpayers with incomes between $100,000 and $200,000 could be liable for the AMT in 2006. A family with two children earning $67,980 could have AMT liability.
The plan at the start of the year was to address the AMT as part of the reform legislation that would develop out of President Bush's Tax Reform Panel's recommendations. That report has been postponed. The expectation is that a temporary extension of the present 2005 AMT exemption amounts will be passed before the 2007 filing season. Nevertheless, practitioners should monitor this development and be prepared to consider shifting deductions and tax preference items into 2005 at year's end.
* FSC/ETI phase-out. The 2004 Jobs Act repeals all of the FSC/ETI rules. However, repeal is gradual, and full repeal does not take place until after 2006. Under the act, taxpayers are able to claim 100 percent of their FSC/ETI benefits in 2004, 80 percent in 2005, 60 percent in 2006, and zero percent (complete repeal) thereafter. However, the full benefit of the FSC/ETI regime generally continues for taxpayers that had entered into contracts in effect on Sept. 17, 2003.
* Puerto Rico/possession tax credits. Tax credits for business activities in U.S. possessions expire for tax years beginning after Dec. 31, 2005. They include credits found in Code Sec. 30A, which provides a Puerto Rico economic activity credit, and Code Sec. 936, creating a tax credit for Puerto Rico and U.S. possessions. Code Sec. 30A has existed since 1996, while Code Sec. 936 first appeared in 1976. Decisions need to be made, as outlined in Notice 2005-21, on the form in which Section 936 corporations elect to continue business.
Law on early distributions
The Tax Court in Lodder-Beckert, T.C. Memo. 2005-162 had some disturbing news for year-end planning of special-need withdrawals from retirement plans. The court held that credit card payments made to cover education expenses for two years prior to an IRA distribution were not allowed as qualified higher education expenses for purposes of avoiding the early-distribution penalty. In so deciding, the court said that it was "reaffirming" the rule that distributions from an IRA, to be free of the penalty, must be used "for the taxable year," meaning that the expense must be incurred, and the distribution used, for the same tax year.
Interpreting Code Sec. 72(t)(2)(E) strictly to read that the distributions are allowed for expenses incurred "for the taxable year," the court held that because the distributions occurred in 2001, and the disputed expenses in 1999 and 2000, years when no IRA distributions were made, the distributions from 2001 were not used for expenses "for the taxable year," and therefore were subject to the 10 percent tax penalty.
By analogy, distributions for other qualified expenses, such as medical expenses in Code Sec. 72(t)(2)(B) and distributions for the purchase of a first home under Sec. 72(t)(2)(F), also should be made in the year in which the expense was incurred to avoid the tax penalty. Some wonder whether this is a short-lived victory for the IRS, and if this apparent rule imposes too tight a deadline to be applicable. However, for the present, attention to timing year-end distributions is advisable.
Unlike most transactional tax planning, year-end tax planning requires attention to a wide array of variables. Within those variables is also the variable of changing laws. The 2005 year-end tax planning season should prove especially challenging on both counts.
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