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Los Angeles Certified Health Business Development Consultant

Last Updated:
Tuesday February 07, 2017

INDEX



TAX HIGHLIGHTS FOR 2005

Last year we reported that in late 2004 Congress passed two pieces of legislation: The Working Families Relief Act of 2004 and The American Jobs Creation Act of 2004. On September 23, 2005 the Hurricane Katrina Tax Relief Act of 2005 was signed into law. Some of the changes that affect individuals and businesses in 2005 are included in these Highlights. In addition, certain provisions of The 2005 Bankruptcy Act and The Energy Tax Incentives Act of 2005 will be discussed.

OVERVIEW

In my opinion, the five pieces of legislation did not bring major tax changes. My comments will touch on those changes I believe will impact your 2005 taxes and some changes in store for 2006. If you read or hear about a tax matter that may affect your tax situation and want my reading on it, give me a call.

A year ago I stated that President Bush may be forced to increase income tax rates by the end of 2005 or by 2006 due to the cost of keeping the ‘peace’ in Iraq, a fight over the Social Security Gorilla, and the increasing trade deficit with China. In addition, you can add the cost of Katrina and fighting world terrorism. I still don’t count out a tax increase in 2006.

That brings us to ‘what can each of us do’ to protect our financial security in view of these huge uncontrollable economic tsunamis.

My reply has always been to stick to the basics. Careful financial planning throughout the year is necessary to keep taxes low and to maximize the cash in your pocket for the short and long term.

INDIVIDUAL TAXES

Alternative Minimum Tax (also quite correctly known as the Alternative Mandatory Tax). The AMT tax was designed to ensure that wealthy taxpayers were not able to escape taxation by exploiting deductions. As the AMT tax is not indexed for inflation, more and more people in lower tax brackets are being ensnared into this subterfuge for a tax rate increase.

According to the Congressional Research Service (CRS), the cost of entirely repealing the AMT would be between $640 billion to $1 trillion, if the tax breaks passed during President Bush’s first term are extended beyond 2010 to the year 2013. In addition, some projections suggest that by 2008, it would be less costly to repeal the regular income tax than to repeal the AMT, according to the January, 2004 CRS report. You figure out if the AMT is going to remain law!

To make sure you don’t wind up paying AMT if you can avoid it, start by projecting your income for the rest of this year and next, at the least. That will help your tax advisor to figure out if you should be shifting income and deductions into 2005, since the AMT disallows many deductions that are otherwise are permitted.

Tax tip: Some of the items to consider regarding AMT are: State and local taxes; home equity loans and other mortgage interest not incurred in buying, building, or improving your residence; incentive stock options (these may generate AMT even when sold at a loss); other itemized deductions.

Health Savings Accounts (HSA) Conceptually, an HSA is an individual retirement account for medical expenses. There are two component parts to an HSA: 1) a high-deductible health insurance plan (HDHP) and a 2) health savings account (HSA). Eligible individuals or their employers buy a high-deductible health insurance plan and then makes deductible contributions to a side account, an HSA.

It appears the new HSAs will work best for the healthy, younger person or family, who currently does not incur large medical expenses. An HSA is established for the benefit of an individual, is owned by the individual, and is portable. For individuals, the HSA is an above-the-line deduction rather than an itemized deduction.

A person is not eligible to establish an HSA if they are enrolled in Medicare, or if they may be claimed as a dependent on another person’s tax return. Distributions from HSAs are made on a tax-free basis.

Tax tip: The rules are complex, so seek the guidance of a professional advisor. Additional information is available at www.msabank.com or www.hsainsider.com

Charitable Contributions: Cash contributions to any U.S. charity between August 28 and December 31, 2005 will be fully deductible and not subject to the usual 50 percent contribution base limitation, and will be exempt from the 3% of excess AGI limitation. (This is a side benefit of the Katrina Emergency Tax Relief Act of 2005)
Tax tip: Let your tax preparer know the amount of cash contributions made between August 28 and December 31, 2005, to take advantage of this benefit.

Auto Contributions to Charity – As of January 1, 2005, the rules changed. For 2005, if the claimed value of a motor vehicle, boat, or plane donated to charity exceeds $500, and the item is sold by the charity, the taxpayer’s deduction is limited to the gross proceeds from the sale.

Social Security Benefit Calculator. The Social Security Administration has launched a new Internet service which offers three increasingly detailed levels of benefit estimates. The simplest, “quick calculator”, asks only for your age and current-year earnings. The most sophisticated requires the user to download software into a home computer and allows him or her to try out various retirement scenarios.

Tax tip: Social Security’s new retirement benefit calculator is at www.ssa.gov/retire

Energy Credits. Individuals may claim a deduction of up to $2,000 for hybrid autos acquired in 2004 and 2005. The 2005 Energy Act replaced the deduction with a credit, discussed below.

Tax tip: The Energy Tax Incentives Act of 2005 creates several new tax credits that apply to property placed in service after December 31, 2005. Thus you should consider to defer making some purchases until next year when you have substantial planning time. Be sure to consult experts in this area, as the information below is summarized and does not contain all provisions of the law.

  1. Beginning 1-1-06, purchasers and lessors of hybrids, lean-burn vehicles, fuel cell vehicles, and alternative fuel vehicles are entitles to a two-part credit consisting of 1) a fuel economy credit ranging from $400 to $2,400, and 2) conservation credit ranging from $250 to $1,000. You must be the original owner of the vehicle. The credit is available for personal use as well as business use vehicles. Basis must be reduced by the credit.
  2. Credit for energy-efficient ‘qualifying’ improvements (insulation, windows, skylights, exterior doors and more) to a primary personal residence by a homeowner made in 2006 and 2007 qualify for a lifetime credit of up to $500.
  3. Solar water heaters, photovoltaic or fuel cell equipment placed in service in the taxpayer’s residence in 2006 and 2007 qualify for a 30% nonrefundable credit.
    An annual credit limit of $2,000 per category is set for solar hot water and photovoltaic expenditures, and $500 for each half kilowatt of capacity of qualified fuel cell property.
  4. A credit of $2,000 is available to the builder of a home that is substantially completed after 2005 and purchased in 2006 and 2007 if the home achieves a 50% improvement in energy efficiency versus a comparable dwelling constructed under the existing International Energy Conservation Code standards. The credit applies to new construction as well as ‘substantial reconstruction and rehabilitation’.
  5. A new deduction (not a credit) is available for the cost of energy-efficient property expenditures for commercial buildings, for property placed in service in 2006 and 2007. Qualified expenditures include 1) interior lighting, 2) heating, cooling, ventilation, and hot water, and 3) the ‘building envelope’.

Capital Gains. The end of the year is the perfect time to examine investments to minimize capital gain income. Taking losses on consistently underperforming investments can offset gains taken on winners, because it may be advisable to sell them to rebalance portfolios. Remember that losses taken in excess of gains offset ordinary income up to $3,000 ($1,500 for taxpayers filing separately).

Many of you have such large capital loss carry overs that you will need to live 100 more years to use up the tax benefit. Capital gains that are absorbed by capital losses and net to zero additional taxable income, can mean ‘free’ money from the sale. Note that we are talking about capital losses from your taxable account, NOT your pension account. Also, that capital losses offset only capital gains, not any ordinary income.

Tax tip: To generate capital gains:

  1. Sell the depreciated (and hopefully appreciated) rental.
  2. Take taxable boot in an exchange.
  3. Sell negative basis limited partnership interest to generate phantom income. There are many old tax shelter partnerships with large negative capital accounts. Maybe it’s time to abandon the interest to the general partner (or sell the interest to a non-relative) and recognize phantom income. Make sure it will be capital gain and not ordinary income before you do the transaction.
  4. Sell the appreciated vacation home.
  5. Sell the highly appreciated personal residence if gains are in excess of the ‘sale of home exclusion’ ($250,000/$500,000) and generate a capital gain that can be absorbed by the capital loss carry overs.
  6. Some appreciated stock is better off not sold, but donated to charitable organizations where they can be deducted at their fair market value.
  7. Capital gains can also be shifted to family members in lower tax brackets through gifts of securities. The basis remains the same for donor and donee.
  8. Pursuant to a recent development you can elect to treat capital gains and qualified dividends as investment income, taxed at ordinary income tax rates, if you have deductible investment interest expense that will offset it.

Expiring Provisions. One of several items set to expire December 31, 2005 is the higher education expense deduction. This provision permits a maximum deduction of $4,000 in qualified tuition and related expenses for taxpayers whose AGI does not exceed $65,000 ($130,000 for married filing jointly), and $2,000 for filers with AGIs between $65,000 and $80,000 ($160,000 for joint filers).

Tax tip: This deduction is attractive to taxpayers who do not qualify for either the Hope or Lifetime Learning credits, so qualifiers may wish to pay in December, 2005 for coursework that begins during the first three months of 2006.

Retirement Planning. While contributions to IRAs may be applied retroactively if made before the filing deadline, contributions to qualified plans (including ‘catch-up contributions”) must be made before the end of the calendar year.

Some taxpayers may have reached the age at which they must take ‘required minimum distributions’ from a qualified plan and should make sure they have done so during the tax year. Those who became age 70-1/2 during 2005 must take their first distribution on or before April 1, 2006; but you can elect to take that first distribution in 2005 so you don’t have two distributions in 2006.

Tax tip: Taxpayers who are not already maximizing contributions to their retirement plans can reduce their AGI by increasing contributions. This has the added effect of increasing the deductibility of medical and other deductions subject to AGI floors.

Maximum contributions to traditional and Roth IRAs are $4,000, with a $500 additional catch-up contribution for people age 50 and over – as long as the taxpayer and his spouse, even if non-working, have earned income that equals or exceed the maximum contribution. Example: Larry is over age 50 and earns over $8,500 is married to Marcia who is under age 50 and not employed. Their maximum IRA contribution is $8,500.

Tax tip: It is time to consider conversions from traditional IRAs to Roth IRAs, which will generate a potentially large tax bill in 2005, as long as the long-term benefits outweigh the current costs. This is also a good time to consider options for next year. That includes to consider contributions to a Roth 401(k) or 403(b) plan which permits you to make contributions from after-tax dollars, and later to receive tax-free distributions.

The 2005 Bankruptcy Act. This information would be applicable for anyone you know who may be contemplating bankruptcy. It is now tougher to file for bankruptcy.
A Chapter 7 bankruptcy is a liquidation of the debtor’s nonexempt assets that are then used to pay off creditors to the extent possible. The debtor emerges from Chapter 7 bankruptcy discharged of any further obligation to pay creditors, except for taxes, alimony, child support, and student loans.
A Chapter 13 bankruptcy is a plan where the debtor reorganizes his or her financial affairs. The debtor receives a discharge only after completing a court-approved repayment plan.

The first major reform to federal bankruptcy laws since 1978 occurred when the President signed into law The Bankruptcy Act, which took effect October 17, 2005. Generally families earning more than the state median, about $49,000 in California, will face huge roadblocks to filing a Chapter 7 bankruptcy on consumer debts and only be allowed to file Chapter 13 which calls for a debt repayment plan. Prior to seeking
the protection of bankruptcy, debtors will be required to pay for debt counseling as a first step.

A brief summary of some of the major tax related changes to the Bankruptcy Act include:

  1. Generally, federal tax debts incurred within 3 years of filing for bankruptcy a) are given priority status, and b) are not dischargeable in bankruptcy.
  2. The debtor is required to provide to the bankruptcy trustee prior to the first creditor meeting copies or transcripts of tax returns ending in the four-year period that ends on the date the petition for bankruptcy was filed. Therefore, failure to file a return or untimely filing generally makes the tax liability not dischargeable.
  3. Tax liability arising from a fraudulent return is not dischargeable.
  4. If the debtor fails to provide the latest tax return at least 7 days before the initial date for the first meeting of creditors, the law requires the dismissal of the Chapter 7 or 13 case.
  5. Retirement plans
    a. To the extent they are exempt under the Internal Revenue Code, a qualified retirement plan, traditional IRA, Roth IRA, multi-employer plan, government plan, and tax exempt plan are excluded from the bankruptcy estate.
    b. Debtor’s loans from his retirement plan are not dischargeable.
    c. The exclusion limit for an IRA account is $1 million. The limit does not apply to the SEP IRA, the 401(k) Roth, or the SARSEP. It also does not apply to IRA accounts rolled over from qualified accounts.
    Tax tip: Two good reasons to keep your rollover accounts separate from other IRA accounts are 1) you can later rollover the account balance into a new employer’s 401(k) account, and 2) the account balance is protected from creditor claims in bankruptcy.
  6. Coverdell Education Savings Accounts (CESA) and Section 529 plans.
    a. An exemption from the bankruptcy laws is allowed for CESA and 529 plans if the debtor contributed to an account where the designated beneficiary is the debtor’s child, stepchild, grandchild, or step-grandchild. Contributions to a CESA must be for a child under 18 years of age.
    b. However, no age limit exists for a donor’s contribution to a 529 plan for the benefit of any other beneficiary.
    c. There are no bankruptcy exclusions, or limited exclusions for funds deposited to the CESA or 529 plan within certain time limits.

BUSINESS TAXES

Production Activity Deduction. The most significant provision for 2005 is the Production Activity Deduction (new code section 199). For 2005 and 2006 the deduction is equal to 3% of the lesser of 1) the qualified production activities income of the taxpayer or 2) taxable income (determined without regard to this provision). For taxable years beginning in 2007, 2008, and 2009, the deduction is increased to 6%, and for taxable years beginning after 2009, the deduction is increased to 9%. The deduction is limited to 50% of the W-2 wages of the taxpayer. The taxpayer is any business entity.

Qualified production activities include the U.S. manufacture, production, growth or extraction of tangible personal property, software development, certain sound recordings, certain qualified film produced by the taxpayer, U.S. production of electricity, natural gas or potable water, construction or substantial renovation of real property in the U.S. including residential and commercial buildings and infrastructure such as roads, power lines, water systems, and communications facilities. and engineering and architectural services preformed in the U.S. and relating to construction of U.S. real property.

Code section 199 contains many provisions and qualifications. If you believe this deduction may apply to your business, you should contact your tax advisor.

Bonus depreciation expired 12-31-04.

Section 179 expensing is $105,000 for property placed in service in 2005 ($108,000 in 2006) The deduction applies to purchases of up to $420,000 for 2005 ($430,000 for 2006). This limitation is scheduled to drop back to $25,000 of purchases in 2007, so consider making your equipment purchases in 2005 and 2006.

As always, I am available to discuss any of these matters with you.

Your resource for all of your tax, financial, and business planning matters,

top


IRS AUDITS S CORPORATIONS


IRS AUDITS S CORPORATIONS

The IRS is launching a new research compliance program of S corporations.  The study will examine 5,000 randomly selected S corporation returns from tax years 2003 to 2004.  The 5,000 represents 1.6 thousandths of 1% of all S corporations.

The last compliance study was in 1984, prior to tax law changes that spurred the growth of S corporations from 724,749 to 3,154,377 in 2002.

Purpose of the audits

Research programs are undertaken periodically to ensure that corporations and individuals pay their fair share of taxes.  Based on study results using statistical analysis, the IRS updates its methods of finding returns that might potentially have problems.

Salary abuse

The impetus for the S corporation study is a result of Social Security hearings early in 2005.  The highlight of the hearings was the loss of payroll revenue to the federal government.  “People are taking salaries that are too low, sometimes as little as zero, to beat the 15.3% FICA tax.  Or there are those who pay themselves $10,000, but take out $90,000 in distributions.”

Inappropriate deductions

The study expects to find a disproportionate amount of inappropriate deductions in small and midsized businesses.

WHAT YOU SHOULD DO BEFORE AN AUDIT

Compensation to owner employees should be reasonable: what you would have to pay a third party to perform your services.  In addition, all expenses should be directly related to the business of the S corporation, and be well documented.  Contact your CPA to determine if you will pass the new IRS research program audit.

As always, I am available to discuss any of these matters with you.

Your resource for all of your tax, financial and business planning matters,

 


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