Alternative Minimum Tax
Last year, Thomas and Gloria Gordon were looking forward to a vacation and making a few home improvements, but Uncle Sam had other plans. Thomas, a psychologist in private practice who also manages an organizational psychology consulting business with his wife, expected that year’s tax bill to be about $46,000. What they ended up paying was closer to $50,000 — an additional $4,000 thanks to a little known “tax trap” called the Alternative Minimum Tax (AMT).
This time around, the Gordons aren’t taking any chances. They are consulting with their tax professional on an end-of-year tax strategy to ensure that they don’t get ensnared in the AMT trap again.
Any accountant will tell you, when it comes to taxes, the Dec. 31 deadline can be as important as April 15. Making the right moves before Dec. 31 can shave thousands off your bill to Uncle Sam. Conversely, failing to act before the New Year can cost you irretrievable tax-cutting opportunities. This year, the stakes are even higher thanks to the passage of the federal Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), the third-largest tax cut in U.S. history, which President Bush signed in May.
Because of the new law’s many attractive tax breaks and various start and “sunset” dates, you might not have another opportunity for similar tax savings in the coming years. Some provisions take full effect immediately and are then phased out over the years. Others disappear from the tax code unless a future law extends their life.
Those extra tax benefits are one reason more middle-income families have a higher chance of owing the AMT this year. The Joint Committee on Taxation estimates that 2.2 million taxpayers will be subject to the AMT in 2003. That’s a 200,000 increase from the number impacted because of the 2001 tax law. The Congressional Research Service reports that by 2010, with inflation and reductions in regular tax, the number of taxpayers affected by the AMT will grow to an estimated 35 million — 33% of all taxpayers. That’s not what was intended.
Congress originally launched the AMT in 1979 to prevent wealthy Americans from taking so many deductions that they wound up paying little to no taxes. “It’s the legacy of an era when tax rates went as high as 70% and the tax code was full of loopholes for the wealthy,” according to Mark Luscombe, CPA, attorney, and principal federal tax analyst for CCH. To counteract those loopholes, the AMT requires taxpayers to add back certain deductions (including state and local income taxes, property taxes, and some medical or investment expenses) and adjustments that are allowed when calculating a taxpayer’s regular taxable income.
If your deductions add up to a disproportionate share of your income, you, like the Gordons, could be hit with the AMT. But you won’t know for sure until you’ve calculated your taxes — twice (first using the regular tax formula and second using the AMT Form 6251). If the result of your AMT return tops your regular tax, you will owe the higher amount.
When the Gordons filled out both 2002 returns, their income under the AMT was $27,000 higher than their regular income tax after they added back state and local taxes and a $10,000 capital gain.
“One thing we plan to do to avoid the AMT is to pay our state and local taxes in January 2004, which will reduce our itemized deductions,” explains Thomas Gordon. “We also plan to reduce our taxable income for 2003 by delaying some of our billings to our customers until January 2004.”
Anita T. Conner, a CPA and principal with a Philadelphia certified public accounting firm bearing her name, says the following scenarios should signal a red flag as to whether you might have an AMT bill this year:
You’ve had to pay the AMT in a previous year. Chances are you may face it again, unless your financial situation has changed dramatically. For example, your income has decreased due to a job loss.
You have itemized deductions such as medical expenses, state, local, and real estate taxes, and certain mortgage interests. These are added back when calculating the AMT.
You have a capital loss carryover to offset capital gains. Capital loss carryovers are not allowed when configuring the AMT, so you would have to pay tax on this.
You have tax-favored stock options. If your employer has awarded you incentive stock options, you have to treat the excess fair market value of the stock over your cost as income for AMT purposes.
Rebalance Your Portfolio
The end of the year is a good time to look at the mix of your investment portfolios, especially if yours didn’t return at least 10% in 2003, says financial planner and CPA Edward Fulbright of Durham, North Carolina. If you have some holdings that have appreciated significantly, now may be the time to cash in. You also might want to sell a few losers, for poorly performing assets can offset any capital gains you might have. Even without gains, up to $3,000 of investment losses can be used to reduce regular taxable income.
Rebalancing your portfolio before the end of the year is even more critical this year because the capital gains and dividend rates have been reduced to 15% for the four highest tax brackets and to 5% for the two lowest tax brackets. The new lower dividend rate applies to the entire year. The capital gains rate reduction, however, did not go into effect until May 6. Any gains earned prior to May 6 will be taxed at 20% while gains realized after May 6 will be taxed at the lower 15% rate.
“This is really helping a lot of people lower their tax bill,” says Fulbright. “I have seen clients lower [their] tax liability by $3,000 or $4,000 because the dividend tax rate dropped from as high as 38.6% on the federal side to 15%.”
One of those clients is Robert Chapman, a 54-year-old adjunct assistant professor of management and special assistant to the dean of North Carolina Central University’s School of Business. “I’m trying to take advantage of this as long as it makes sense,” says Chapman, who plans to retire in 11 years. “I recognize the tax law can change again, so I don’t want to lose time or miss opportunities.” Indeed, the lower investment income rates are only temporary. Without further congressional action, they’re scheduled to expire in 2009.
One of the stocks Chapman says he plans to sell is Cisco (Nasdaq: CSCO), which he bought in 1996 at $6 a share. The new lower capital gain rate can shave $565 off his tax bill. Chapman is also considering gifting the stock to one of his daughters who will use it toward graduate school expenses. Because she is in the 15% tax bracket, she would only pay 5% capital gains tax on the proceeds and can qualify for Lifetime Learning Credit (a tax credit of up to $2,000 per family toward post-secondary expenses), says Fulbright. The family would save $1,500 to $2,000 in taxes.
Steps for Today’s Business Owner
Today’s business owner can also benefit from the new tax laws in an effort to reduce his or her taxes. “It’s a great time to replace old equipment,” explains Patrick Largie, principal with Watson Rice, a New York-based national accounting firm.
While it usually makes sense for business owners to purchase business equipment before year-end, this year, thanks to the new tax law’s attempts to spur business growth, there’s an even bigger tax incentive (see Enterprise, this issue). The two biggest benefits for businesses under the new law are increases in the small business expensing election, commonly known as the Section 179 deduction, and the 50% bonus depreciation deduction.
Family practitioner and public health physician Dr. Robert Adair says he plans to make the most of the new tax benefits by making purchases for his New York and New Jersey medical offices. “Surgical supply houses are informing doctors that their
purchases may be tax deductible and are even providing extra incentives such as buy-two-and-get-one-free specials on certain equipment,” he says.
The Section 179 deduction allows a small business to deduct up front the cost of new equipment bought, delivered, and put into service (but not necessarily paid for) before Dec. 31 rather than depreciate it over a period of years. The maximum deduction under Section 179 of the Internal Revenue Code has also been increased to $100,000 in 2003 and 2004 — up from $25,000 the previous year. In other words, companies can reduce their taxable income by up to $100,000 a year. Also, the maximum investment for qualifying equipment has been doubled to $400,000.
Another tax strategy for business owners might be to reduce taxes by electing to take bonus depreciation. Certain types of equipment purchased after May 5 qualify for bonus depreciation of 50% of the value in addition to normal depreciation deductions.
According to Largie, employing this end-of-year strategy makes for significant tax savings. Dr. Adair, for example, plans to spend $5,000 on office furniture and $15,000 on medical equipment. The busy doctor, who is also the city physician for the township of Englewood, New Jersey, often makes two or three trips a day to either of his offices or to one of the four hospitals where he’s on staff. As a result, Dr. Adair is considering buying an SUV for $50,000 to use specifically for these professional rounds. If he makes these purchases and puts the equipment into service on or before Dec. 31, his taxable income will be reduced by at least $70,000 — the total of his purchases.
“Since Dr. Adair is in a combined federal and state 40% tax bracket, he will realize a tax savings of a least $20,000,” explains Largie.
But understand that not all equipment qualifies. Covered equipment includes computers and automobiles used for business in addition to — for the first time — furniture. For a list of eligible assets, see IRS Publication 535 (www.irs.gov). According to the IRS, ineligible property includes income-producing property (investment or rental property) and property held by an estate or trust or purchased from relatives.
“Better make use of this now because it goes back down to 30% at the end of 2004 if the provisions are not extended,” says Largie.
What the Tax Law Changes Mean for You
American citizens didn’t wait long to see the extra cash generated by the new tax laws. Employers lowered the amount of federal tax withheld from their workers’ paychecks, reflecting lower tax rates for most people and a larger standard deduction for married couples. Also, for many taxpayers who claimed the Child Tax Credit last year, the Treasury mailed checks as an advance payment of the credit’s increase. The new tax law also lowered the tax rates for long-term capital gains and qualifying dividends, allowing taxpayers to reduce their estimated tax payments for the year following May 2003.
However, there are other changes that affect individuals. These changes include:
Revised 2003 Tax Rate Schedules. The tax rate brackets of 27%, 30%, 35%, and 38.6%, have been reduced to 25%, 28%, 33%, and 35%, respectively. Also, the 15% rate bracket for married taxpayers filing jointly and qualifying widowers has expanded to twice that of single filers. And the maximum taxable income subject to the 10% tax rate has increased to $7,000 for single taxpayers and married taxpayers filing separately ($14,000 for married taxpayers filing jointly and qualifying widowers).
The basic standard deduction for married taxpayers filing jointly and qualifying widowers has increased to $9,500 (twice that of single filers). The standard deduction for married taxpayers filing separately has increased to $4,750 (the same as that of single taxpayers).
The maximum Child Tax Credit has increased from $600 to $1,000 per child.
A reduction in capital gains. The maximum tax rate on net capital gain (i.e., net long-term capital gain reduced by any net short-term capital loss) has been reduced from 20% to 15% (and from 10% to 5% for taxpayers in the 10% and 15% tax rate brackets) for property sold or otherwise disposed of after May 5, 2003 (and installment sale payments received after that date). The same 15% (or 5%) maximum tax rate that applies to net capital gain also applies to dividends paid by most domestic and foreign corporations after Dec. 31, 2002.
The new law affects all businesses. Those who are self-employed are included. Changes in this law include:
A special first-year depreciation allowance of 50% for qualified property acquired after May 5, 2003. (Except for property acquired under a binding written contract in effect before May 6, 2003). The depreciation limit for vehicles subject to the 50% allowance is increased by $7,650.
A limit on the Section 179 expense deduction is increased to
$100,000 for qualified property. This limit is reduced by the amount by which the cost of Section 179 property placed in service during the year exceeds $400,000. This definition of Section 179 property has been expanded to include off-the-shelf computer software.And for corporations: The installment due date for 25% of any corporate estimated tax payment otherwise due in September 2003 has been changed to Oct. 1, 2003. The due date for the remaining 75% of the September 2003 estimated tax payment has not changed.
SOURCE: INTERNAL REVENUE SERVICE
Common Tax Errors to Avoid
Everyone is looking for ways to reduce expenses, reduce taxes, and keep more year-end income.
The best approach to shaving money off your tax bill to Uncle Sam is to simply do your homework. The more information you have at your fingertips regarding deductions and expenses, the more you’ll save. Remember, the list of deductions that come with your tax return is only a fraction of the total deductions you and your family may be entitled to. It’s your responsibility to find those missing deductions, because the Internal Revenue Service will not help you. It isn’t their responsibility to help you find tax deductions. That’s your job!
However, the IRS does offer little reminders from year to year that might help you when you do file your annual taxes. One immediate reminder is to avoid common errors. Here are a few items to check off when you send in this year’s tax return:
- Check your math, particularly if someone else is doing your taxes for you.
- Make sure your Social Security number is written correctly on the document.
- Make sure you’ve claimed all of your dependents, including children who are away in college, or elderly parents who depend on your for financial support.
- If you are single, but you have dependents living with you (whether they are your children or not), you might qualify for a lower tax rate available to you as head of household or surviving spouse.
- If you’re married, you might explore the option of filing separate returns rather than a joint return. In some cases, filing separate is much more beneficial than filing jointly.
- If you are blind or 65 years of age or older, you might be eligible to claim for additional standard deductions.
- Double check that your W-2 and all Form 1099s are accurate. If they’re wrong, have them corrected immediately.
- If you work for two or more employers, make sure you claim a credit for any overpaid Society Security taxes withheld from your wages by both employers.
- If you own property, make sure that you distinguish deductible real property taxes from assessments paid for repairs to streets, sidewalks, sewers, gutters, and other improvements that benefit specific properties in specific neighborhoods.
- Remember that only a portion of your Social Security benefits may be taxable. If your income doesn’t exceed a certain amount, then none of it may be taxable. Don’t miss certain end-of-the-year deadlines to set up IRA contributions.
- Keep
copies of all documents that you send to the IRS. - And always sign your documents.
SOURCE: THE ERNST & YOUNG TAX GUIDE 2003