In depth tax issues
In Depth on Social Security
What is a marginal tax rate?
Individuals and corporations under a progressive tax system have higher tax rates as taxable income increases. For example, a married couple with taxable income of $60,000 would be in the 28% marginal tax bracket. For every $1 deduction found, 28 cents would
be saved. It is important to know your marginal tax bracket to make informed tax
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How do I determine whether I should increase my house mortgage or pay it down with any extra money?
This decision should be based entirely on "opportunity cost." For example, if you borrow $100 at 8% and the money can earn 10%, you are ahead of the game. The same simple analogy applies to deciding whether a mortgage should be paid off. Factor in income taxes as another variable and look at your opportunity cost. If you pay off a $100,000 mortgage at 8% you are basically saying, "I do not think I could earn more than 8% on other investments."
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How can a CPA help me, beyond preparation of my income taxes?
There are important services that a closely held business and its principals need beyond income taxes. For instance, as a small business owner, have you thought about what happens to your business after you retire or pass away? You should have a plan! We call this process "business succession planning." Preparing a business valuation is a valuable service we can provide in formulating a succession plan. In addition, as part of the business succession plan, financial planning becomes a vital service. These are just some of the valuable services a CPA can provide a small business.
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How can I tell which professional CPA firm is the best choice for my business?
You should evaluate professional CPA firms based upon the expertise and experience level of the professional staff, and by the services the firm offers. The professional staff at Dennis and Associates are all CPAs with a minimum of seven years of professional experience. We offer many of the services business owners and individuals will need, such as tax planning and compliance, business valuations, retirement and personal financial planning, estate planning, business and accounting system consulting, payroll, bookkeeping, and management consulting.
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What is the number one tax planning strategy I should consider?
Maximum contribution to your retirement plan is the number one tax planning strategy. Timing of income and deductions is also widely used. Deferring income (either through qualified retirement plans or delayed billings) or "bunching" deductions (paying mortgage interest or two years of property taxes in one year) can produce favorable results if the situation is right. Of course, you should consult your tax professional to see if this strategy is appropriate for you.
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What are the inherited property and basis rules?
The “cost” for tax purposes (or “basis”) an individual gets in property he inherits from another is an important area and is too often overlooked when families start to put their affairs in order.
The general rule is referred to as the “step-up” basis rule. That is, the heir receives a basis in inherited property equal to its date of death value. So, for example, if Uncle Harry bought Kodak stock in 1935 for $500 and it's worth $5 million at his death, the basis is stepped up to $5 million in the hands of his heirs and all of that gain escapes income taxation forever.
The step-up basis rule applies to inherited property that's includible in the deceased's gross estate, whether or not a federal estate tax return was filed, and it also applies to property inherited from foreign persons, who aren't subject to U.S. estate tax. The rule applies to the inherited portion of property owned by the inheriting taxpayer jointly with the deceased, but not the portion of jointly held property that the inheriting taxpayer owned before his inheritance. The step-up basis rule also doesn't apply to reinvestments of estate assets by fiduciaries. Note also that for property inherited from individuals dying after 2009, the amount of property appreciation to which a step-up basis will apply will be subject to various dollar limitations.
It's crucial for the step-up basis rule to be understood so that disastrous tax errors are not made.
For example, if, in the above example, Uncle Harry, instead of dying owning the stock, decided to make a gift of it in honor of his 100th birthday, the step-up in basis would be lost. Property that has gone up in value acquired by gift is subject to the “carryover” basis rules: the donee takes the same basis the donor had in it (just $500), plus a portion of any gift tax the donor pays on the gift.
The basis “step-up” rule can become a “step-down” rule as well. That is, if a decedent dies owning property that has declined in value, its basis is lowered to the date of death value. Proper planning calls for seeking to avoid this loss of basis. In this case, however, giving the property away before death will not preserve the basis: when property which has gone down in value is the subject of a gift, the donee must take the date of gift value as his basis (for purposes of determining his loss on a later sale). The best idea for property which has declined in value, therefore, is for the owner to sell it before death so he can enjoy the tax benefits of the loss.
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What are the rules for business meals and entertainment?
This type of expense requires you to jump through several extra hoops to qualify as deductible and is subject to limitations. Nevertheless, if you pay careful attention to rules outlined below, the expenses should qualify as deductible.
(1) Ordinary and necessary business expenses. All business expenses must meet the general deductibility requirement of being “ordinary and necessary” in carrying on the business. These terms have been fairly broadly defined to mean customary or usual, and appropriate or helpful. Thus, if it is reasonable in your business to entertain clients or other business people you should be able to pass this general test.
(2) “Directly related” or “associated with.” A second level of tests specially applicable to meals and entertainment expenses must also be satisfied. Under them, the business meal or entertainment must be either “directly related to” or “associated with” the business.
“Directly related” means involving an “active” discussion aimed at getting “immediate” revenue. Thus, a specific, concrete business benefit is expected to be derived, not just general goodwill from making a client or associate view you favorably. And the principal purpose for the event must be business. Also, you must have engaged actively during the event, via a meeting, discussion, etc.
The directly related test can also be met if the meal or entertainment takes place in a clear business setting directly furthering your business, i.e., where there is no meaningful personal or social relationship between you and the others involved. Meetings or discussions that take place at sporting events, night clubs, or cocktail parties—essentially social events—would not meet this test.
If the “directly related” test cannot be met, the expense may qualify as “associated with” the active conduct of business if the meal or entertainment event precedes or follows (i.e., takes place on the same day as) a substantial and bona fide business discussion.
This test is easier to satisfy. “Goodwill” type of entertainment at shows, sporting events, night clubs, etc. can qualify. The event will be considered associated with the active conduct of the business if its purpose is to get new business or encourage the continuation of a business relationship. For meals, you (or an employee of yours) must be present. That is, for example, if you simply cover the cost of a client's meal after a business meeting but don't join him at it, the expense does not qualify.
(3) Substantiation. Almost as important as qualifying for the deduction are the requirements for proving that it qualifies. The use of reasonable estimates is not sufficient to stand up to IRS challenge. You must be able to establish the amount spent, the time and place, the business purpose, and the business relationship of the individuals involved. Obviously, you must set up careful and detailed record-keeping procedures to keep track of each business meal and entertainment event and to justify its business connection. For expenses of $75 or more, documentary proof (receipt, etc.) is required.
(4) Deduction limitations. Several additional limitations apply. First expenses that are “lavish or extravagant” are not deductible. This is generally a “reasonableness” test and does not impose any fixed limits on the cost of meals or entertainment events. Expenses incurred at first class restaurants or clubs can qualify as deductible.
More importantly, however, once the expenditure qualifies, it is only 50% deductible. Obviously, this rule severely reduces the tax benefit of business meals and entertainment. If you spend about $50 a week on qualifying business meals, or $2,500 for the year, your deduction will only be $1,250, for tax savings of around $300 to $400.
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What is the tax treatment of buying a hybrid automobile?
A purchaser of a hybrid passenger automobile (referred to below as a “hybrid”) in 2005 can qualify for a federal income tax deduction of up to $2,000. Beginning in 2006, the deduction is replaced by a tax credit of up to $3,400.
Tax deduction available in 2005. Buying a hybrid in 2005 has one tax advantage—a deduction of up to $2,000 of the portion of the cost of the hybrid that is attributable to its ability to use electricity as a power source (the “incremental cost”). Discussed below are the main points to keep in mind about the deduction.
Tax credit beginning in 2006. For new hybrid vehicles purchased beginning Jan. 1, 2006, the purchaser is allowed a tax credit of from $400 to $3,400 depending on the model. A credit is usually more advantageous than a deduction because a tax credit is subtracted dollar-for-dollar off the bottom line of your federal tax bill, while a deduction simply reduces taxable income.
The amount of the credit depends on the fuel efficiency of the vehicle. The more gas it saves, the higher the credit. However, calculating the credit is a bit complicated, with the exact amount of your credit depending on three separate factors: the weight of the vehicle, its fuel economy, and its lifetime fuel savings. This information should be available from your dealer. You can calculate the credit yourself using the tables in the law, or I would be happy to assist you.
The credit is set to expire at the end of 2010, but for many hybrid models the incentive will end much sooner. That is because the law limits the credits to 60,000 vehicles from each automaker. Once a manufacturer has sold 60,000 hybrid vehicles, the tax credit for that manufacturer's hybrids is slowly reduced over the next five consecutive quarters, eventually dropping to zero. For manufacturers who are currently offering popular hybrids, the tax credit could begin to be reduced as soon as fourth quarter 2006. For other manufacturers, their hybrid cars will have the full tax credit for a longer period.
Here are some additional points about the credit:
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What are the tax consequences to you of your company's offer to grant you an incentive stock option (ISO) on its stock.
The grant of the ISO to you will not be taxable. Nor will your later exercise of the ISO—except, as discussed below, that it may make you subject to the alternative minimum tax (AMT). For example , if the market value of the stock goes to $150 per share and you exercise the option and buy the 1,000 shares with a market value of $150,000 for the $100,000 option price, you won't be subject to regular income tax on your $50,000 bargain purchase.
By Jan. 31 following the close of the year in which you exercise an ISO, your employer is required to provide you with a written or, if you consent, an electronic statement containing information about the stock that you received when you exercised your ISO. This information will include the date that the ISO was granted, the date when the stock was transferred to you, the number of shares that were transferred, and the stock's FMV at the time the ISO was exercised. From this information, we will be able to determine how long you need to hold the stock to qualify for favorable long-term capital gain rates on the difference between the price you paid for the stock and the amount you realize on its sale (see below) or, if you do not hold the stock long enough for this favorable tax treatment, how much additional compensation income will be attributed to you from the ISO exercise.
If you later sell the stock, say when its value reaches $200 per share, for $200,000, then your $100,000 profit will be taxed as a capital gain in the year of sale. Although the sale is taxable, no income tax will be withheld from your paycheck.
If you want to qualify for the favorable tax treatment available with an ISO (so the $100,000 employment-related profit is taxed at capital gain rates, rather than at the higher ordinary income tax rates imposed on regular compensation), then you cannot make a “disposition” of the stock: (1) within two years after the ISO is granted; or (2) within one year after the stock has been transferred to you. A “disposition” includes a sale, exchange, gift, or similar lifetime transfer of legal title.
If you dispose of the stock before both of the required holding periods have expired, then you will be taxed as if you had received compensation in the year of disposition. You will have to treat the gain on that premature disposition as ordinary income to the extent of the lesser of: (1) the stock's FMV on the date of exercise minus the option price; or (2) the amount realized on the disposition minus the basis of the ISO stock (i.e., the stock you acquire through an ISO exercise).
For example, assume again that you buy $150,000 worth of your company's stock for $100,000 by exercising the ISO and later sell this stock for $200,000. The spread between the value on the date of exercise ($150,000) minus the option price ($100,000) would be $50,000. The difference between the amount realized on the disposition of the stock ($200,000) minus the option price ($100,000) would be $100,000. Consequently, your $100,000 gain on the premature disposition would be ordinary income to the extent of $50,000—the lesser of $50,000 or $100,000.
If you receive less on the premature disposition than the value when you exercised the ISO and the disposition wasn't a sale to a related taxpayer, then the taxable amount is limited to the amount you realized on the sale minus your adjusted basis in the ISO stock. For example, if you sold the stock for $130,000, then you would have $30,000 of compensation income ($130,000 amount realized less $100,000 adjusted basis).
Although your ISO has a five-year exercise period, the tax rules that apply to ISOs require that you exercise the option no later than three months after you terminate your employment. There are some exceptions to this employment requirement if you transfer from one related company to another, such as from a parent to a subsidiary.
For stock acquired under options exercised after Oct. 22, 2004, any remuneration that arises when stock is transferred on the exercise of an ISO or on the disposition of the stock is not subject to FICA or FUTA taxation. Additionally, any income resulting from a disqualifying disposition of stock acquired under an ISO is not subject to withholding.
The special tax treatment allowed to taxpayers for regular tax purposes when an ISO is exercised—i.e., no taxation at the time the ISO is exercised, deferral of tax of the benefit associated with the ISO until disposition of the stock, and taxation of the entire profit on the sale of stock acquired through ISO exercise at capital gain rates if ISO holding periods are met—isn't allowed for AMT purposes. Under the AMT rules, you must include in your AMT income, in the year the ISO stock becomes freely transferable or isn't subject to a substantial risk of forfeiture, the bargain purchase price, which is the difference between the ISO stock's value and the lower price you paid for it. For most taxpayers, this occurs in the year the ISO is exercised. This means that even though you aren't taxed for regular tax purposes, you may still have to pay AMT on the bargain purchase price when you exercise the ISO, even though you don't sell the stock, and even if the stock price declines significantly after you exercise the ISO. Under these circumstances, the tax benefits of your ISO will clearly be diminished.
As you can see, these technically complex ISO rules require careful tax planning strategies.
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What is the gradual elimination of estate tax and how your estate may be affected by the 2001 Tax Act?
The 2001 Tax Act gradually eliminates the estate tax by increasing the amount that is exempt from the tax over several years, reducing the top rate over several years, and finally repealing the estate tax for individuals dying after 2009. But there is a quirk in the law. To comply with budgetary rules, the 2001 Act contains a so-called sunset rule under which the pre-2001 Act rules return after 2010 unless Congress provides otherwise at some future time. This means that the estate tax is repealed only for those who die in 2010. The changes are quite complicated and will require most estate plans to be reevaluated.
Background. Under pre-2001 Act law, there was no gift tax and no estate tax on the first $675,000 of combined transfers during life or at death, for gifts made and individuals dying in 2001. These two taxes were tied together under a unified system having a top rate of 55%. However, there were differences between the gift tax and the estate tax. One difference potentially affected the income tax of donees (recipients) of gifts and heirs of estates. A donee generally got the donor's basis (usually cost) for a gift. As a result, if there was a gift of appreciated stock, for example, the donee had a taxable gain if he sold at the gift value. Property acquired from a decedent, however, generally got a basis equal to its value at his death. This meant that, on a later sale by the heir, he didn't have to pay income tax on the appreciation in the property that occurred while it was held by the decedent.
Exemption increases and rate reductions. The 2001 Act increased the exemption from $675,000 for 2001 to $1 million for 2002 and 2003, $1.5 million for 2004 and 2005, $2 million for 2006 through 2008, and $3.5 million in 2009. But only the estate tax exemption amounts will rise to more than $1 million. The gift tax exemption amount remains at $1 million for all years after 2001, and the gift tax is not being repealed during 2010 as the estate tax is. Thus, there will be a modified unified estate and gift system after 2003, and no unified system in 2010. Under the sunset rule, the estate and gift system will be re-unified in 2011, with the exemption going down to $1 million for both estate and gift tax purposes.
The top estate and gift tax rate dropped to 50% in 2002, 49% in 2003, and 48% in 2004. It drops to 47% in 2005. It will drop to 46% in 2006, and 45% in 2007 through 2009. In 2010, there will be no estate tax, and the top gift tax rate will be 35%. Under the sunset rule, the top estate and gift tax rate reverts to 55% in 2011.
Change to basis rules. When the estate tax is repealed in 2010, the basis rules will be changed to be similar to the gift tax rules but with many opportunities for heirs to get increases in basis. For example, it will be possible to increase the basis of assets received from an individual dying in 2010 by $1.3 million and by an additional $3 million for assets going to a spouse. Under the sunset rule, the step-up in basis rules return for 2011.
Other changes. The 2001 Act contained a number of other changes, some of which are retroactive. It simplified and reduced the generation-skipping transfer (GST) tax, which is a special tax that's designed to prevent individuals from avoiding the estate tax by transferring assets to a generation below the next one (e.g., grandfather transferring to grandson rather than to son). The 2001 Act also improved the exemption for conservation easements and the provision that allows deferral of estate tax on a closely held business. It even created a retroactive refund opportunity for some estates that had farms that were valued based on actual use rather than highest and best use.
The 2001 Act eliminated the family-owned business deduction for individuals dying after 2003. (The amount of this deduction was coordinated with the exemption amount, and the combined amounts could not exceed $1.3 million. As noted above, after 2003, the exemption amount alone exceeds $1.3 million.)
Uncertain impact on planning. The uncertainty of whether the sunset provision will ever come into play and whether an individual will die during a period of increasing exemption amounts makes planning difficult. Moreover, because of the way the law works, when income tax costs are factored in, some heirs will face higher tax costs if their benefactor dies in 2010 when the estate tax is repealed than they would if he died before 2010.
What to do now. Individuals should continue to write wills and develop estate plans to ensure that their assets will pass as they desire and that special needs of particular heirs will be properly addressed. This is so even if there is a good chance of survival until a year when estate tax won't be owed because of the increasing exemption or repeal. Individuals who may have an estate larger than the increasing exemption amount—or the $1 million amount that will apply for 2011 (when the estate tax is restored one year after it is repealed)—should make annual exclusion gifts each year. The gift tax annual exclusion allows you to give $11,000 to an unlimited number of donees each year without paying gift tax. By doing this, you remove the gift amounts from your estate and save estate tax. In addition, you remove the post-transfer growth in the gifts from your estate. Other steps to reduce estate tax include setting up a life insurance trust, establishing a grantor retained annuity trust (GRAT), and placing one's residence in a special type of trust called a qualified personal residence trust (QPRT).
Special factors for married couples. Married couples should make sure that each spouse has sufficient assets in his or her own name to take advantage of the increased exemption. In addition, their wills should establish a so-called bypass or credit-shelter trust. Such a trust is funded with an amount equal to the exemption from estate tax. The survivor gets income from the trust and the assets in the trust pass to the children free of estate tax on the survivor's death. Assets above the exempt amount can be given outright to the surviving spouse or placed in a special marital trust for him or her. This approach may have to be altered depending on the year involved and the size of the estates.
Record retention. With the scheduled change to a modified carryover basis system in 2010, it is essential that you retain all records of cost or other basis. For purchased items, this means receipts and statements showing the amount you paid for it. For items inherited before 2010, basis ordinarily is the date-of-death value of the item. For property acquired by gift, the donee's basis usually is the same as the donor's. For depreciable property, basis is reduced to reflect allowable depreciation.
New look at plan. While the 2001 Act may well save estate tax to the benefit of your heirs, it has added many new planning complications. I invite you to contact our office to set up an appointment so that we can properly reexamine your estate plan to help to keep your estate tax, and income tax for your heirs, to a minimum.
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What are the rules for home office expense deduction for self-employed taxpayer?
If you're self-employed and work out of an office in your home, and if you satisfy the strict rules that govern those deductions (discussed below), you will be entitled to favorable “home office” deductions—that is, above-the-line business expense deductions for the following:
In addition, if your home office is your “principal place of business” under the rules discussed below, the costs of travelling between your home office and other work locations in that business are deductible transportation expenses, rather than nondeductible commuting costs. And you may also deduct the cost of computers and related equipment that you use in the home office, without being subject to the “listed property” restrictions that would otherwise apply.
Tests for home office deductions. You may deduct your home office expenses if you meet any of the three tests described below: the principal place of business test, the place for meeting patients, clients or customers test, or the separate structure test. You may also deduct the expenses of certain storage space if you qualify under the rules described further below.
Principal place of business. You're entitled to home office deductions if you use your home office, exclusively and on a regular basis, as your principal place of business. (What “exclusively and on a regular basis” means is not entirely self-evident. We can help you figure out whether your home office satisfies this make-or-break requirement.) Your home office is your principal place of business if it satisfies either a “management or administrative activities” test, or a “relative importance” test. You satisfy the management or administrative activities test if you use your home office for administrative or management activities of your business, and if you meet certain other requirements. You meet the relative importance test if your home office is the most important place where you conduct your business, in comparison with all the other locations where you conduct that business.
Home office used for meeting patients, clients, or customers. You're entitled to home office deductions if you use your home office, exclusively and on a regular basis, to meet or deal with patients, clients, or customers. The patients, clients or customers must be physically present in the home office.
Separate structures. You're entitled to home office deductions for a home office, used exclusively and on a regular basis for business, that's located in a separate unattached structure on the same property as your home—for example, an unattached garage, artist's studio, workshop, or office building.
Space for storing inventory or product samples. If you're in the business of selling products at retail or wholesale, and if your home is your sole fixed business location, you can deduct home expenses allocable to space that you use regularly (but not necessarily exclusively) to store inventory or product samples.
Amount limitations on home office deductions. The amount of your home office deductions is subject to limitations based on the income attributable to your use of the home office, your residence-based deductions that aren't dependent on use of your home for business (e.g., mortgage interest and real estate taxes), and your business deductions that aren't attributable to your use of the home office. But any home office expenses that can't be deducted because of these limitations may be carried over and deducted in later years. We can help you figure out how these limitations affect your home office deductions.
Sales of homes with home offices. If you sell—at a profit—a home that contains, or contained, a home office, the otherwise available $250,000/$500,000 exclusion for gain on the sale of a principal residence won't apply to the portion of your profit equal to the amount of depreciation you claimed on the home office. In addition, the exclusion won't apply to the portion of your profit allocable to a home office that's separate from the dwelling unit. Otherwise, the home office won't affect your eligibility for the exclusion.
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What are the tax consequences of donating a used car to charity?
One of the negative aspects of buying a new car is the annoyance involved with getting rid of your old car. Many individuals find the trade-in allowance offered by dealers (if any) to be well below the car's true value. But the alternative of selling the car on your own involves the expense of advertising as well as the commitment of time needed to meet with potential buyers, accompany them on test drives, negotiate a fair price, etc.
For these reasons, some taxpayers consider a different option for their old cars: donating them to charity. An increasing number of charities have turned to car-donation programs. You may have seen ads from some of these organization in your local newspaper urging individuals to donate their old cars. The donation approach saves you the trouble of trying to sell the car. Many charities offer the added convenience of picking up the car at your home.
In taking this approach, however, bear in mind that the amount of the deduction you will be allowed to claim is subject to special limitations. In many cases, the deduction you can claim is less than your view of the car's value. If you compare the tax savings from a donation with a dealer's trade-in offer, the offer may not seem as small.
For cars worth over $500, the deduction will be the amount for which the charity actually sells the car, if it sells the car without materially improving it. This limit applies to any motor vehicle designed for road use, including vans and trucks, as well as to boats and airplanes.
Since most charities do sell the cars they receive, it's likely that your donation will be limited to the actual sale price. Furthermore, these sales are often at auction or in bulk and typically result in sales below “Blue Book” value. Also, you won't know the amount of your deduction until the charity has sold the car and reported the sale proceeds to you (see below).
Only if the charity uses the car in its operations or materially improves the car before selling it will your deduction be based on the car's fair market value at the time of the donation. In that case, fair market value is usually set according to the “Blue Book” listings for used cars published by the National Automobile Dealers Association. IRS will accept the value in the “Blue Book” or another established used car pricing guide if the guide lists a sales price for a car that is the same make, model, and year, sold in the same area, and in the same condition, as the car you donated. In some cases, this value will exceed the amount you could actually get on a sale.
However, if the car is in poor condition, because it needs substantial repairs or is unsafe to drive, and the pricing guide only lists prices for cars in average or better condition, the guide won't set the car's value. Instead, you must establish the car's true market value by any reasonable method. Many used car guides show how to adjust value for items such as accessories or mileage.
In any case, you must itemize your deductions to get the tax benefit; you can't take a deduction for a car donation if you take the standard deduction.
Making sure the charity qualifies and is legitimate. You won't be entitled to a charitable deduction unless you donate your car to an eligible charitable organization. In some cases, the transaction is more complex because private fund-raisers may be operating car donation programs on behalf of charities. This is legitimate as long as the private company is acting as the agent for a qualified charity. I can help if you have any doubts about the qualification of any donee you are considering.
Proving your right to the deduction. If you donate your used car to charity, make sure you take the steps needed to substantiate your tax deduction.
If the charity sells the car, you will need a written acknowledgement from the charity containing your name and tax ID number, the vehicle ID number, a certification that it was sold at arm's length to an unrelated party, the gross proceeds of sale, and statement that the deduction cannot exceed the proceeds. The charity should provide you with this acknowledgement within 30 days of the sale.
If, instead, the charity will use (or materially improve) the car, the acknowledgement needs to certify the intended use (or improvement) and the intended duration of the use, along with a statement that the car will not be sold before completion of the use or improvement. In this case, the acknowledgement should be provided within 30 days of the donation.
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What are the tax implications for individuals facing a divorce or legal separation?
Unfortunately, in addition to the difficult personal issues the process entails, several tax concerns need to be addressed to ensure that tax costs are kept to a minimum and that important tax-related decisions are properly made.
Support provisions. Where one spouse is to be making support payments to the other upon divorce or separation, the payments are deductible by the payor and taxable to the payee if they qualify under the tax rules for “alimony.” To qualify, the payments must (i) be required under the divorce decree or separation agreement (i.e., voluntary or “extra” payments won't qualify), (ii) be in cash only (not goods or services), and (iii) be required to end at the death of the recipient spouse. Also, (iv) the parties must be living in separate households. The parties can elect to have payments that qualify be treated as not qualifying (but not vice versa).
Support payments for children (“child support”) aren't deductible by the paying spouse (or taxable to the recipient). These include payments specifically designated as child support as well as payments which otherwise might look like alimony but are linked to an event or date related to a child. For example, say a spouse is to pay “alimony” of $3,000 a month, dropping to $2,000 a month at a specified date. If the date coincides with a child's 18th or 21st birthday, the “extra” $1,000 will be characterized as child support and not be deductible by the paying spouse (or taxable to the recipient spouse).
Tax planning for support payments generally seeks to make them deductible if the paying spouse is in a higher tax bracket than the recipient, as is often the case. The tax savings for the paying spouse can be shared with the recipient through higher payment amounts or other benefit provisions. For example, if having payments qualify as alimony will save the paying spouse $5,000 in tax and will cost the receiving spouse only $2,000 (determined by multiplying the alimony amount by the individual's marginal income tax bracket), the paying spouse can offer additional payments in the divorce negotiations to cover the recipient's tax cost and a share of the additional tax savings.
Since alimony payments are required to end at the death of the receiving spouse, as noted above, the parties may wish to provide for life insurance for that spouse as part of the arrangement.
Dependency exemptions. To some extent, the parties can determine who is entitled to claim the dependency exemption for their dependent children. The exemption for the child goes to the spouse who has legal custody of the child. However, that spouse can waive his or her right to the exemption, thus allowing the non-custodial spouse to claim it. In general, tax planning calls for the spouses to agree to have the exemption go to the spouse who can extract the greater tax benefit from it. As discussed above in connection with tax savings from support arrangements, the tax benefit can then be “shared” with the other spouse via increased support payments or in some other fashion.
The dependency exemption entitles the spouse who claims it to more than just the exemption. For example, the child tax and the higher education (Hope and Lifetime learning) credits are only available to the spouse who claims the child as a dependent. (Note, however, if the custodial parent waives the right to the exemption, the custodial parent can still claim the child care credit for qualifying expenses if the child is under 13.)
If a custodial spouse is waiving the right to the dependency exemption for a child, it's done on Form 8332. This can be done on an annual basis or one time to cover future years. Where the waiving spouse will be receiving support payments from the other spouse, the waiving spouse often prefers the annual approach so he or she can refuse to grant the waiver if support payments are late or have been missed.
Property settlements. When property is split up in connection with a divorce, there are usually no immediate tax consequences. Thus, property transferred between the spouses won't result in taxable gain or loss to the transferring spouse. Instead, the receiving spouse takes the same basis (cost) in the property that the transferring spouse had. (The receiving spouse may have to pay tax later, however, when the recipient spouse sells the property. For example, if a spouse receives a $300,000 vacation home, but the transferring spouse's basis was only $150,000, the recipient spouse will have a taxable gain if he or she later sells the house for more than $150,000, unless the spouse qualifies to exclude part or all of the gain by first making the house his or her principal residence). This “non-recognition rule” also applies to certain transfers, incident to divorce, to a spouse or former spouse, of so-called non-statutory stock options and/or rights to nonqualified deferred compensation that an individual has received as compensation for employment and that haven't yet been recognized for income tax purposes. Moreover, the transferee spouse or former spouse, rather than the transferor, is taxed on the income attributable to these transferred options or deferred compensation rights.
Special tax rules apply to certain categories of property. In particular, please call me to make sure the arrangements for your home, pension benefits, and certain business interests, discussed below, are properly structured to minimize potential tax costs.
Personal residence. In general, if a married couple sells their home in connection with divorce or legal separation they should be able to avoid tax on up to $500,000 of gain (as long as they owned and used the residence as their principal residence for two of the previous five years). If one spouse continues to live in the home and the other moves out (but they remain owners of the home), they may still be able to avoid gain on the future sale of the home (up to $250,000 each), but special language may have to be included in the divorce decree or separation agreement to protect the exclusion for the spouse who moves out. If the couple doesn't meet the two year ownership and use tests, any gain from the sale may qualify for a reduced exclusion by reason of unforeseen circumstances.
Pension benefits. A spouse's pension benefits are often part of a property settlement. When this is the case, the commonly preferred method to handle the benefits is to get a “qualified domestic relations order (QDRO).” A QDRO gives one spouse the right to share in the pension benefits of the other and taxes the spouse who receives the benefits. Without a QDRO the spouse who earned the benefits will still be taxed on them even though they are paid out to the other spouse.
A QDRO isn't needed to split up an IRA, but special care must be taken to avoid unfavorable tax consequences. For example, if an IRA owner were to cash out his IRA and then pay his ex-spouse her share of the IRA as stipulated in a divorce decree, the transaction could be treated as a taxable distribution (possibly also triggering penalties), for which the IRA owner would be solely responsible. However, the taxes and penalties can be avoided, if specific IRS-approved methods for transferring the IRA from one spouse to the other are used. For example, money can be transferred tax-free from one spouse's IRA to the other spouse's IRA in a trustee-to-trustee transfer, as long as the transfer is required by a divorce decree or separation agreement. Also, the transfer shouldn't take place before the divorce or separation is final, or it may be treated as a taxable distribution.
Business interests. When certain types of business interests are transferred in connection with divorce or separation, care must be taken to make sure “tax attributes” aren't forfeited. In particular, interests in S corporations may result in “suspended” losses, i.e., losses that are carried into future years instead of being deducted in the year they are incurred. Where these interests change hands in connection with a divorce, the suspended losses may be forfeited. If a partnership interest is transferred a variety of more complex issues may arise involving partners' shares of partnership debt, capital accounts, built-in gains on contributed property, and other complex issues.
I'm not suggesting that the interests discussed above shouldn't be part of property settlement negotiations: only that the parties be aware of the tax consequences that their transfer may generate.
Estate planning considerations. The upheaval a divorce causes in family relations and property holdings makes it imperative for the parties to reassess their wills and estate plans in connection with the divorce. First, the typical will in which all property is left to a surviving spouse is no longer likely to reflect the testator's wishes. Mutual family goals, often incorporated in reciprocal wills, are likely to have changed substantially. Second, the property to be left by the spouses may have changed hands via a property settlement. One spouse may be getting substantial holdings he or she didn't previously possess, making it necessary to devise a new estate plan. Finally, guardianship and trustee issues for surviving minor children must be addressed. That is, who will manage the assets of, and serve as guardian for, minor children in the event of the death of the parents.
Medical insurance. If your spouse participates in an employee group health plan that is subject to COBRA, you should know that the plan has the obligation to make COBRA health care continuation coverage available to you, as a qualified beneficiary, if there is a divorce or legal separation. This availability of health coverage extends for 36 months, beginning on the date of the divorce or legal separation. You, however, would have to pay for the coverage (unless, of course, the divorce court orders your spouse to pay for it). This option to buy COBRA health care coverage is available to you even if your spouse discontinued your coverage while the divorce was pending.
Tax records. Make sure you get copies of, or access to, any records or documents that can have an impact on your tax situation. You need copies of joint returns filed with your spouse along with supporting documentation. Also, records relating to the cost of jointly owned property or property transferred to you in connection with the divorce are essential. You will need to establish cost when these assets are eventually sold. And, of course, all documents relating to the divorce or separation itself should be retained for tax (and other legal) purposes.
Filing status. The timing of your divorce or separation can have an impact on how you file your tax return. If a “final” decree or divorce or, in the case of separation, decree of separate maintenance, is issued by the end of the year, then you can't file your tax return for the year as a married person. Your filing status will be “single.” However, if you cover more than half the costs of a household in which a child of yours lives, you may qualify for more favorable “head of household” rates. Please call if you would like me to review the rules for qualifying for this tax filing status.
If an above-described decree hasn't been issued by year-end, you are treated as still married even if you are separated from your spouse under a separation agreement or “nonfinal” decree. In this case, you may still file jointly with your spouse. This filing status may result in lower overall tax for you and your ex-spouse, but may put you at risk for an unpaid tax obligation of your spouse's (although you may be protected under “innocent spouse”rules, and an election to limit your liability may be available in certain circumstances). It also requires contact between the parties to prepare the joint return, which may not be desirable in some circumstances. Further, the alimony deduction discussed above can't be taken on a joint return.
The other available filing status is “married filing separately,” which is the least favorable status. However, again, if you cover more than half the costs of a household in which a child of yours lives, and your spouse hasn't been a member of the household during the last six months of the year, you may qualify for a more favorable filing status.
Providing income data to spouse who has custody of child under 14. Be aware that if while you and your spouse are still considered married, you and your spouse decide to file separate returns, and your spouse has custody of your child under age 14 who has investment income, you may have to provide to your spouse any information about your taxable income that's needed to properly figure the child's income tax under the kiddie tax rules (which tax the child's investment income at the parent's highest rate). If you will have custody of the child, you may be in the position of having to get income information from your spouse.
Adjusting income tax withholding. The changes caused by divorce may require you to adjust the amount of income tax that your employer withholds from your paycheck. The calculation of your withholding on the Form W-4, Employee's Holding Allowance Certificate, that you gave to your employer is based on your married status and on the earnings of both spouses. When you get divorced, you should submit a new Form W-4 with the revised information. The fact that deductible alimony payments will be made (or taxable alimony received) should also be taken into account. This will ensure that the correct amount of tax is withheld.
Notifying IRS of a new address or name change. If you will be moving, or if you are changing your name because of divorce, file Form 8822 with IRS so you will receive any notices or correspondence from IRS promptly.
Deducting legal fees. Finally, to what extent can you deduct the legal fees incurred in connection with the divorce? In general, since a divorce is a “personal” undertaking, the legal fees are nondeductible. However, as you can readily see from this discussion, many complex tax issues can be involved in a divorce. And a fee paid for tax advice (including setting up the support arrangement), is deductible as a miscellaneous itemized deduction. (This means it's added to other items in this category, if any, e.g., investment expenses, and is deductible to the extent the total exceeds 2% of adjusted gross income.)
To get a tax deduction for the part of your legal fee that represents tax advice, it's important to have your attorney indicate on his or her bill to you what portion represents tax-related service. If your attorney merely submits a bill “for legal services rendered” you may have difficulty convincing IRS how much, if any, is deductible.
Other legal fees in connection with divorce that may save you taxes include costs to collect alimony payments (but not costs to resist collection). Also, if legal work is involved in getting marital assets, the part of fee allocable to the property can be added to its basis. This can save you tax when the property is disposed of.
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What does social security do?
The social security tax—also known as FICA (for Federal Insurance Contributions Act)—is no more popular than any other tax; however, it differs in many ways from other taxes. Social security tax dollars are designed to provide a level of financial security for covered workers and their families.
The taxes each worker pays are matched dollar for dollar by his employer. Together, these funds are used to pay for four different types of benefits:
Each of these benefits is explained in greater detail in this Guide to Social Security. The important thing to remember, however, is that social security is not just a retirement plan. It also is a system of replacing lost income due to disability or death. It is supported by the tax dollars of workers and their employers, and it provides benefits regardless of any other benefit plans sponsored by a worker's employer.
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How can I build social security protection?
If a worker or self-employed person is at least in his 30s, has been working and paying social security taxes most of his adult life, and expects to continue working into his 60s, he generally already is (and will continue to be) insured for the full range of benefits. Still, some people should be concerned about building social security protection—particularly those who worked for a while under social security but not long enough to build up sufficient credits for benefits. The following examples indicate situations that may raise concerns about building sufficient social security protection:
Quarters of coverage. To acquire credit for benefits, a worker must have a certain number of “quarters of coverage.” The total earnings in a calendar year determines the number of quarters of coverage. To acquire one quarter of coverage for 2005, a worker must earn $920 (up from $900 for 2004). Thus, a worker who earns $3,680 or more in 2005 earns four quarters of coverage—the maximum number that can be credited per calendar year. For example, a worker who earns $2,200 (more than $920 × 2, but less than $900 × 3) would earn two quarters of coverage. The quarter of coverage amount increases each year to keep up with average wage increases.
Fully insured. The total number of work credits needed to qualify for benefits depends on a worker's age and the type of benefit to be received—i.e., whether it is a retirement, disability, or death benefit. Once a worker has 10 years' credits (40 quarters of coverage) he is “fully insured” for retirement and survivors' benefits, even if he never works again.
Caution: Being fully insured guarantees that a benefit will be payable, but it does not assure that a worker will receive any particular benefit amount. Benefit payments are determined according to a worker's cumulative earnings, subject to the annual maximum. Thus, the greater the worker's lifetime earnings, generally the greater his potential benefit.
If a worker was born before 1929 (became age 65 before 1994), he does not need 40 quarters of coverage to be fully insured. Instead, for purposes of receiving retirement benefits, he would need one less quarter for each year that he was born before 1929. For example, a person born in 1927 would need only 38 quarters or 91/2 years of work to be fully insured for retirement benefits.
For survivor's benefits, a worker is considered fully insured if he has 10 years of work at any age. If he dies before age 62, however, he is considered fully insured if he worked at least the following number of years:
|Age at Death||Years of Work|
|28 or younger||1-1/2|
Illustration: After three years of work, Mary Smith quits her job at age 25 to raise a family. The work credits that she earned will provide survivors' insurance protection until she is age 34. (Look down the “Years of Work” column to three years, then across to age 34.) If she dies before age 34, her children are eligible to receive monthly benefits; however, if she dies after age 34, her survivors' insurance protection is gone. If she wants to maintain her protection, she must work and earn the minimum required wages for one quarter for each later year.
For disability benefits, as with survivor's benefits, a person generally is “fully insured” if he has at least 10 years' credited work. If the person becomes disabled before reaching age 62, whether he is considered “fully insured” is determined as follows:
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How can I protect my Social Security Coverage?
A worker's investment in social security is “as sound as the U.S. Government,”. As with any other investment, however, a worker still should evaluate where he/she stands from time to time. The best method of doing so is to make sure that the government records are in order. Since October 1999, the Social Security Administration (SSA) annually has mailed an earnings record providing an updated summary of rights and expected benefits to each worker who is not currently receiving benefits and is at least age 25. The statement arrives about three months before the worker's birthday.
Workers also may request an earnings record statement at any time. To request a statement, a worker must either (1) submit a completed Form SSA-7004, also known as the Personal Earnings and Benefit Estimates Statement (PEBES) or Social Security Statement, or (2) submit a request through the Social Security Administration (SSA) Website. Copies of Form 7004 are available by calling 800-772-1213 (800-SSA-1213). An explanation of the PEBES is set out on the SSA Website.
SSA is required by law to make any changes to the earnings statement within three years, three months, and 15 days after the year ends in which the worker earned the income.
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When should I retire?
Some people dream of retiring early. Others prefer to continue working and saving money until they are age 65, or even past age 65. Although other issues—such as benefits available from an employer—factor into a decision about when to retire, a worker has three options under the social security system:
Although most people think of 65 as the “magic” age for retirement—the age at which a worker can stop working and receive a full social security benefit—this is true only if the worker reached age 65 before 2003. If born in 1938 or later, a worker is not eligible to retire with full benefits until he reaches the age indicated in the following table:
|Year of Birth||Full Social Security Retirement Age|
|1937 or earlier||65|
|1938||65 and 2 months|
|1939||65 and 4 months|
|1940||65 and 6 months|
|1941||65 and 8 months|
|1942||65 and 10 months|
|1955||66 and 2 months|
|1956||66 and 4 months|
|1957||66 and 6 months|
|1958||66 and 8 months|
|1959||66 and 10 months|
|1960 and after||67|
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How can I calculate My retirement benefits?
The amount of a worker's monthly social security retirement benefits is based on his earnings covered by social security over the years. The monthly payment that he receives depends on his basic benefit, known as the “primary insurance amount.” This amount is used in determining the amounts for all other benefits.
A worker was born before 1938 and retires at age 65. His basic benefit is identical to his actual retirement benefit. If he retires at age 62, his retirement benefit is 80 percent of his basic benefit.
The number of years used in calculating a worker's basic benefit depends on when he reaches age 62. All of his earnings up to the maximum covered under social security are considered. Actual earnings for past years are adjusted to take account of changes in average wages since 1951. These adjusted earnings are averaged together and a formula is applied to the average to obtain the worker's basic benefit.
Retiring early. If a worker was born before 1938 and retires on social security when he is 62, his basic benefit will be reduced by 20 percent to reflect the three extra years of payments. The closer the worker gets to age 65, the smaller the reduction. For example, when a worker is 11/2 years before his full social security retirement age (at age 631/2 if born before 1938), the benefit is cut by 10 percent rather than 20 percent.
If a worker was born in 1938 or later and elects to retire and receive social security benefits when he is 62, his basic benefit will be reduced by a greater amount than if he had been born in 1937 or earlier, because his full social security retirement age is greater than age 65. For example, the percentage reduction is 25 for a person born in 1943 who elects to begin receiving benefits at age 62 (i.e., in 2005). The benefit reduction for a person born in 1937 or earlier who elected to retire and begin receiving benefits at age 62 was only 20 percent.
Observation: Individuals born in 1938 reached age 62 in 2000, making 2000 the first year in which the phased-in increase to the full social security retirement age became effective for individuals electing to begin receiving benefits at age 62.
The following table shows the percentage reductions for a person electing to retire at age 62:
Reduction in Benefits if Elect to Retire at Age 62
|Year of Reduction||Monthly Birth Reduction||Total Percentage Percentage|
|1937 or earlier||.555||20.00|
|1960 and later||.500||30|
Postponing retirement. If a worker postpones his retirement past full social security retirement age, he will be entitled to a special “delayed retirement bonus” for each month that he postpones receiving benefits after reaching full social security retirement age (whatever that may be in his case), up to age 70. No additional adjustments occur for postponements past age 70. Changes to the Social Security rules in 1983 increased the percentage adjustment for individuals retiring late. The percentage adjustments for individuals who postpone their retirement, based on their years of birth, is as follows:
|Year of Birth||Yearly Rate of Increase||Monthly Rate Increase|
|1930||4.5%||3/8 of 1%|
|1931-1932||5.0%||5/12 of 1%|
|1933-1934||5.5%||11/24 of 1%|
|1935-1936||6.0%||1/2 of 1%|
|1937-1938||6.5%||13/24 of 1%|
|1939-1940||7.0%||7/12 of 1%|
|1941-1942||7.5%||5/8 of 1%|
|1943 or later||8.0%||2/3 of 1%|
Cost-of-living increases. Regardless of the age at which a worker retires, he will be entitled to the same annual cost-of-living increases that everyone on social security receives. For those already receiving benefits in 2004, the cost-of-living increase for 2005 is 2.7 percent. If the result is not an even multiple of $.10, the amount is rounded down to the next multiple of $.10.
Monthly retirement benefits for 2005. The estimated average monthly retirement benefit for retired workers for 2005 is $955. The estimated average monthly retirement benefit for an aged couple, both of whom are eligible for retirement benefits, is $1,574 for 2004. The maximum monthly retirement benefit for persons receiving social security retirement benefits in 2005, after reaching full social security retirement age, is $1,939.
Observation: An individual who reached age 65 sometime between September and December 2004 will not reach full social security retirement age (age 65 and four months) until early 2005. Similarly, an individual who reaches age 65 between July and December 2005 will not reach full social security retirement age (age 65 and six months) until the first half of 2006.
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