November 2005

Page 1 – Save Energy, Save Taxes

I would like to emphasize three points in this article.  First of all, the credits discussed begin next year in 2006—they do not affect your 2005 tax determination.  They will impact year-end planning, however, as you decide to incur a qualified expenditure in 2005, or wait until 2006 to qualify for the credit. 

While the credit for the alternative vehicle may appear attractive, qualified alternative fuel automobiles, including the popular hybrid vehicles, qualify for a generous deduction in 2005, in addition to the deduction for state and local sales taxes that expires at the end of 2005. 

The article discusses credits.  Our tax system is moving more and more toward using tax credits to implement social and economic policy, rather than using tax deductions.  This change is significant.  A credit reduces your income tax dollar for dollar for the amount of the credit—a credit is worth the same to a high income taxpayer as it is to a low income taxpayer, while the benefit of a deduction depends on your marginal income tax rate.  A dollar of deduction will save more in taxes for a taxpayer in the 35% tax bracket is it will for a taxpayer in the 25% tax bracket.  Most tax credits cannot reduce your tax below zero, and the benefit most credits is reduced for “high income” taxpayers.  The definition of “high income” in most cases is lower than one might think.

Page 2 – Self-employeds: Lock in Deduction for Health Insurance

There are two issues at play in the discussion of health insurance premiums for the self-employed.  First of all, a self-employed individual is granted a deduction for health insurance premiums his spouse and dependents. (Sorry about the gender language, but it is simply too awkward to always use ‘his or her’ in this discussion). The deduction is denied if the self-employed can participate in a subsidized program provided by his spouses’ employer.  My wife is covered by a subsidized plan and I am covered under her plan, although my premiums are not subsidized.  Unfair as it is, my premiums are not deductible.

The second issue deals with the health insurance benefit plan offered by the self-employed individual to his employees and himself.  In the case of the proprietorship, the premium attributed to the proprietor is not a business expense, but a personal deduction—it does not reduce self-employment income.  In the case of an S-Corporation, the premiums are deductible, but the premium attributable to a 2% or more shareholder is an addition to compensation income—subject to FICA and reportable on Form W-2.  The shareholder then takes the deduction on his tax return. The deduction for the 2% shareholder is limited to his income (W-2 plus K-1 income) from that particular S Corporation.  It is confusing and technical, and I am sure many errors are made in tax reporting.

Like-Kind Exchanges

This is also referred to as a Section 1031 exchange or tax deferred exchange.  Books are written about this opportunity and an entire cottage industry as developed to support it.  Rather than a complete analysis, a couple of comments may help. 

First of all the provisions are mandatory and not elective.  The business that trades an old vehicle in as a partial down payment on a new vehicle participates in a 1031 exchange.  Good tax planning dictates, therefore, that any loss property be sold rather than traded in order to salvage some tax benefit from the loss.

Second, three party exchanges are possible.  The important point is that such exchanges must be carefully planned—if you see the cash, you will be taxed.  You must “do the numbers” before entering into a 1031 exchange.  The exchange is tax deferred, not tax free.  Where debt is involved, you may find that a significant portion of the gain is being currently taxed.  I have seen too many cases where amount of tax deferred was less than the professional fees involved in implementing the exchange—hardly good tax planning.

Finally, the term “like-kind” is a term of art.  Before planning for a tax deferred exchange, make sure the property is truly like-kind.  You may be surprised.

Page 3 – Late Year Strategies.

The advice here is a fairly standard year-end strategy.  The advice on deferring billing, however, raises a real business issue.  Timely collecting accounts receivable—getting the cash into the bank—is of prime importance to every successful business.  Deferring billing for tax purposes is an invitation to permanently save taxes by converting that receivable into a bad debt.  From a business perspective, it is far better to pay the tax now in a sure collection, rather than risking a bad debt.

A brief mention is made of the Alternative Minimum Tax (AMT).  If your itemized deductions put you into an AMT position, the net effect is to disallow the deduction.  A deduction that reduces you income tax by $1 will increase your AMT by $1.  If you believe you are in an AMT position, we may be able to plan to salvage some the benefit of your deductions.

Page 4 – Placing Your Home in a Trust.

I have written in other areas about the exotic planning discussed in books and seminars that have little practical value.  The Qualified Personal Residence Trust (QPRT) is one of those areas.  It is designed as an estate planning device.  In considering the use of a QPRT, one should first ask the question if an estate tax problem exists.  If there is a potential problem, will a QPRT help?  The problem with the QPRT is that one must give up the ownership of their home and, if they live “too long” they must pay rent to live in their home.  Most people find this unacceptable. 

July 2005

The Page One article, Location, Location, Location, is a very limited discussion on where to park your investments, or more appropriately, from which pocket should you invest.  Elsewhere on the website is an article discussing investments, the use of an allocation model and how this may govern from which pocket you should invest.  Share this with your investment advisor and give me some feedback.  The concepts do make some sense.

The bullet points at the end of the article raise two issues for me.  The mutual fund companies are very competitive, and each wants to have the top performing fund.  The fund managers achieve their goals by adjusting their portfolios, selling and purchasing securities.  The mutual funds pay out the any capital gains incurred in the form of dividends, which are taxable to the investor, you and me.  As most mutual fund dividends are reinvested, we incur a tax obligation without receiving any cash with which to pay the tax.  One strategy to minimize the initial tax is to research when the mutual fund typically pays out its capital gains dividend, and invest after the dividend is paid. Because the market usually compensates for dividends, you will receive the same value while avoiding the tax on that first capital gain dividend.

Some mutual funds are more sensitive to the tax issue than others, and limit or time their investment activity to minimize the tax impact on their investors.  These are known as tax managed funds.  Their published performance may not be as stellar, but when you consider your tax cost of holding the investment, the tax management fund may make more sense.

The strategy of reinvesting dividends has made many investors wealthy.  For many investors, there comes a time to redeem mutual fund units to fund retirement.  At the point with withdrawals exceed dividend income, it makes tax sense to stop reinvesting dividends and take them the dividends as cash as a component of your withdrawals.  The dividend income taxable to you, whether received or reinvested, but the sale of mutual fund units will result in a capital gain.  By reducing the number of units sold you are reducing the taxes currently due.

The Page Two article, Breaking Down Construction Costs, demands one caution.  Before embarking on this strategy, do some analysis to determine the actual income tax benefit.  Breaking down the construction costs is a relatively easy matter for new construction, but it can be very costly for an existing building.  You will want to make sure the tax benefits (and the tax audit exposure) are worth the cost. 

Page Four discusses the private annuity.  This is the stuff of estate planning seminars and journal articles.  In almost thirty five years of practice, I have seen only one private annuity. The private annuity may work for a very few, but it has major problems.  First of all it is an unsecured promise to pay.  If for some reason the purchaser cannot or will make payments, there is no recourse.  The tax costs can be high for the annuitant/seller if he or she outlives his actuarial life expectancy, and many tax benefits are lost to the purchases if the annuitant/seller dies prematurely.  I find this technique to be of academic interest but of little practical use.

Finally, I invite you to read, mark, learn and inwardly digest the final article, Stock Donations Save Taxes.  This is an area where you can do some good in the world and save in potential income taxes in a way that is risk free under current US law.  Unfortunately this technique is not as effective in Canada.  In an era where society is relying more and more on the non-profit community to provide for those in need, the gift of appreciated stock is truly a win-win situation.

May 2005

In discussions with new clients, and in every letter that accompanies a tax return sent to a client, I stress the importance of reviewing the tax return before signing and filing.  The article on Page One, Revisit Your Tax Return, stresses some of the benefits, of reviewing your tax return, but there are others. 

Errors happen.  In the haste to file early, a Form 1099 may have been overlooked, or perhaps something just doesn’t seem right after comparing the tax return with that of the prior year.  If a Form 1099 was missed, you will receive a notice from the IRS in about 18 months assessing the additional tax, plus a penalty.

If a tax return needs to be corrected, you should file an amended tax return.  This will not only get you “right” with the IRS, but will avoid the penalty that will be assessed if the IRS finds it first.

The Page Four article on the Alternative Minimum Tax, AMT, is worthy of spending a few extra minutes of review.  For most people, the AMT is a surprise that limits the tax benefits they thought they were going to receive.  In today’s economy, many products and services are promoted by promising a tax benefit for buying the product or service:  “do that major home remodeling project now and deduct your sales tax.”  In most cases, the AMT serves to limit the amount of your itemized deductions, placing a minimum on the amount of taxes you pay for the year.  If an additional deduction reduces your income tax below that minimum by $1, you will incur an AMT of $1.  Although nobody wants to pay more tax (well at least most people), the result is particularly harsh if a decision was made based on the tax benefits that the AMT took away.  That leads back to the cardinal rule in tax planning—a bad business or investment decision that only looks good because of the promised tax benefits, it still a bad business or investment decision. 

Other aspects of the AMT cause one to prepay their tax.  For example, the exercise of an Incentive Stock Option, ISO, may incur an AMT liability.  In many such cases, however, there will be reduced tax when the stock acquired through an ISO is sold.  Analysis is required to determine how much of the AMT is an additional tax and how much is merely a prepayment of tax.  The point is that the AMT in this situation may by be as bad as it may first appear, and the AMT is only one of the factors to consider in the exercise of an ISO.

March 2005

The Page 1 article, Doing Business as an S Corporation, deserves reading.  For most small businesses, the preferred choice of entity is the corporation making the election to be taxed as an S Corporation.  One point in the article needs some additional explanation, and one important point was not even mentioned.

The article mentions the tax on built-in gains for an existing corporation that later elects to be taxed as an S Corporation.  This tax applies to appreciated assets.  The most common appreciated asset I see in practice is the accounts receivable of a corporation that reports on the cash basis of accounting.  The collection of those cash basis accounts receivable, net of the payment of cash basis accounts payable, will be subject to the tax on built-in gains after the corporation makes an S Corporation election.  Any existing corporation contemplating an S Corporation election should seek advice before making such an election, and should consider a formal valuation of the business.

One of the restrictions on permissible shareholders for an S Corporation is that no non-resident alien may be a shareholder.  The Canadian living in the United States, along with his or her fellow shareholders, should weigh carefully the benefits of an S Corporation election, and the related costs of losing the election.  If a Canadian shareholder of an S Corporation should give up his US residence and return to Canada, the corporation will lose its S Corporation status.

A popular option for the formation of a business entity in the State of Washington is the Limited Liability Company (LLC).  The LLC can be an attractive option for the new business, and it should be evaluated along side the S Corporation.  Again, there is a major caution for Canadians using the LLC.  Any business with Canadian resident shareholders, or a company doing business in Canada should avoid using the LLC form.  The LLC most likely will result in double taxation.

The article on Page 2, Ready, Set, Deduct raises an important point, but misses two others.  First of all, the election can only be made on a timely filed tax return (including extensions).  If the tax return is filed late, the deduction is denied and you never will receive any tax benefit for start-up expenses.  The other point is the article only applies to pre-operating expenses, including those incurred by an existing business in expansion activities.  It is important to establish the line between pre-operating and operating.  That line is not clearly defined in the law, so it must be established by the taxpayer.  I advise my clients to recognize the fact that there are pre-operating expenses, and to engage in business activity as soon as possible.  It is better to document the transition from pre-operations to operations now, rather than leave it to the IRS several years down the line.

I would like to make two observations about the Page 3 article on Trusts.  Most articles on Trusts, including this article, deal with taxpayers residing in Common Law States.  Washington, however, is a Community Property State.  Much of the planning in a Community Property State is different so we should talk before you establish a trust.  The discussion of the QTIP Trust does not apply if one of the spouses is not a US citizen.  There is an article on Canadian Estate Planning in the Policies and Documents section of the Web site that discusses this issue in more detail.

Finally, the article deals with domestic trusts.  Foreign trusts are an entirely different topic, one that can be both costly to administer and costly in taxes.  The trust, by the way, is primarily a planning tool—it is not an income tax tool.  Trusts generally will not save income taxes, but may in fact cost you even more.

January 2005

The January 2005 issue discusses the new tax law.  While it is very informative, I have always believed that the focus should be on those items where there is a planning opportunity, or where we must take some action.  That will be the focus of my comments.

The sales tax deduction is the big news for Washington residents.  The TAX REPORT article was written before the latest guidance was issued. 

Click here for a more complete discussion of the sales tax deduction. 

The article Domestic Producers Get New Tax Break is the real sleeper in the new law.  Many businesses who don’t think of themselves as “producers” will qualify.  For example, it appears some of the activities of my dentist client might qualify.  This is an area to think outside of the box and ask questions.

November 2004

Page two of the November 2004 issue contains the article, Cross the IRS off Your Gift List.  The principles in the article pertain only to gifts by U.S. Citizens or residents—other principles apply to gifts by others of U.S. property.  The Gift Tax is imposed on the person making the gift, and not on the recipient.  The receipts of a gift of non-U.S. property from a non-U.S. person to a U.S. Citizen or resident will not result in a U.S. Gift Tax.  Note, however, that there may be income tax reporting requirements for such gifts. 

More significant are the comments on gifts to one’s spouse.  The rules in the article only apply to gifts to one’s spouse were the spouse is a U.S. Citizen.  Different rules apply to gifts to a spouse who is not a U.S. Citizen, even though the spouse is a permanent resident of the United States. 

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