Mid-Year Maneuvers

Summer time is neither lazy nor hazy for Brigitte Johnson Herron, 46, of Silver Spring, Maryland. “I work full time as communications director of a nonprofit organization,” she says. “My husband Reginald [also 46] is in sales, so he’s busy, too. We have two children: 8 years, and an 18-month-old. They obviously need to be cared for while we’re at work, and that becomes more difficult in the summer when school is out.”

Fortunately, help is available from Uncle Sam in the way of tax savings. As summer approaches, savvy planning can lead to sizzling tax breaks for parents and for those who want to mix business travel with pleasure. At the same time, business owners and investors may find mid-year to be an ideal time for locking in tax breaks for the remainder of 2004.

“I send a mid-year letter to my clients, telling them what to do in terms of tax planning,” says Dywane Hall, a principal in the Alexandria, Virginia, office of LPL Financial Services. “I want to make sure they’re fully funding their 401(k) plans, for example, and that they make enough estimated tax payments to avoid penalties. I remind some clients that if they want to set up a SIMPLE retirement plan for their company or for self-employment income, they must act by Oct. 1 to get the benefits for 2004.”

Taking the Pressure Off Parents
Other people have even more pressing needs. While school is out, the Herrons must find childcare for their 8-year-old son. “We’re looking at day camps,” says Brigitte. “We might send him to a sports camp or an art camp, depending on where we think he might enjoy himself.” Parents like the Herrons should know there are several tax options that help take the financial burden off caring for children. Here are a few of them:

Dependent care tax credits. Fortunately, money that parents spend on childcare will qualify for a dependent care credit. “In 2004, as much as $3,000 that you spend on one child under age 13 will qualify,” says Genevia Gee Fulbright of Fulbright & Fulbright, an accounting firm in Durham, North Carolina. “For two or more children, the maximum is $6,000.” Just a couple of years ago, those ceilings were $2,400 and $4,800.

In order to get this credit, the money must be spent for childcare so that a parent can go to work or be a full-time student. “Homecare, daycare, and day camp tuition is covered, but money you spend on overnight camp won’t qualify for this credit,” says Fulbright. If your family income is more than $43,000, the credit rate is 20% — lower incomes get a credit rate as high as 35%.

To see how this might work, suppose you and your spouse both work and your joint income exceeds $43,000. While your two young children are out of school, you send them to day camp, paying $7,000 in fees this year. In this situation, the first $6,000 is eligible for a 20% credit, which cuts your tax bill by $1,200 — that equals 20% of $6,000.

Flexible savings accounts. “The dependent care credit is in addition to the child tax credit, which is available to many families,” says Crystal Alford-Cooper, a certified financial planner with Law & Associates, in Glen Echo, Maryland, and an affiliate with Raymond James Financial. “Extra savings might be available if you or your spouse can participate in an employer’s flexible savings account (FSA) that covers dependent care.”

Up to $5,000 can be contributed to an FSA and used for dependent care expenses, tax-free. As long as your tax bracket is 25% or higher (over $58,100 in taxable income on a joint return this year), you’re better off using an FSA to pay for childcare.

Suppose you spend $7,000 on day camp. The first $5,000 can be paid from an FSA. If you’re in a 25% tax bracket, you’d save $1,250, or 25% of $5,000. “Using $5,000 from the FSA reduces the amount you can use for the dependent care credit from $6,000 to $1,000,” says Fulbright. So your dependent care credit would save you another $200, or 20% of $1,000. Now your total tax savings would be $1,450 ($1,200 plus $200), which might be enough to buy all the clothes and gear your kids need for their sessions at camp.

Extra Tax Breaks For Entrepreneurs
Children also figure in mid-year tax planning for Andre DeBose, 45, and his wife, Claudia, 40, of Fairfax Station, Virginia. Andre, a management consultant, has a vending machine business on the side, while Claudia heads a multicultural books reseller at www.colorfulworld.com.

“We both pay our two sons to work for us,” says Claudia. “They work throughout the year but especially during the summer when they’re out of school. Although they’re only 14 and 12, there are things they can do, such as stocking machines, packing orders, and so on. We keep records of the work they do and pay them a reasonable amount for those jobs.”

Listed below are other tax advantages and benefits that entrepreneurs should be mindful of for next year’s filing:

Income shifting. As a result, the family can enjoy tax savings. “Money you pay as compensation is fully deductible at rates up to 35%,” says Bernie Kent, a CPA and partner at PricewaterhouseCoopers in Detroit. “Your child or grandchild can earn up to $4,850 in 2004 without owing any federal income tax. That number, which is equal to the standard deduction for single taxpayers, moves up annually to keep pace with inflation.”

Say you hire your teenaged daughter to help with your business this summer and she earns $2,000. If you’re in a 35% tax bracket, you cut your federal income tax by $700 this year (35% times $2,000), while your daughter won’t owe any tax. Your family will be ahead. Moreover, the benefits can go beyond tax savings.

“In many relatively affluent families,” says Hall, “the children may not realize the sacrifices the parents have made to achieve that level of success. My own children have worked for me, and I recommend the same strategy for clients. They should start their children off earning money as young as possible. Your kids should know how much work it takes to earn $150 for a pair of shoes.”

Work Opportunity Tax Credit. You don’t have to hire your children to benefit from tax breaks if you’re an employer. John Paul Williams III, 32, of Hayward, California, owns a termite control business that now includes nine full-time employees as well as two part-timers. “Business has been good,” he says, “so I plan to hire more employees. I’m aware that I might qualify for tax credits.”

Williams is referring to the Work Opportunity Tax Credit, which is payable to employers who hire qualified individuals. “The maximum credit is 40% of the first $6,000 of wages, or $2,400,” says Fulbright. “An individual must perform at least 400 hours of services for the employer to have their wages qualify for taking the full 40% credit. An employer must have individuals certified prior to hiring them, and they must be from one of nine targeted groups to be entitled to this credit.” Those groups include members of a family that is receiving or recently received Temporary Assistance; 18- to 24-year-old family members who are receiving or recently received food stamps; and 18- to 24-year-old residents of one of the federally designated empowerment zones, enterprise communities, or renewal communities. “Clients of mine have used this tax credit when it was called the Targeted Jobs Credit,” says Fulbright. “It works out to be a win-win situation for all involved.”

Tax-deferred retirement plans. Another win-win situation may result from creating a retirement plan: business owners and employees alike may benefit from tax-deferred growth. As of this writing, Williams was scheduled to meet with Gary Kerchner, an agent with Northwestern Mutual Life in San Jose, California, to discuss his options.

“At mid-y
ear 2004,” says Kerchner, “it may still be possible to shelter income from 2003. If you received a filing extension for your 2003 income tax return, you have until the due date of that return to create and contribute to a simplified employee plan (SEP) for last year. That can be a tax-saver for the owners of small companies and people with self-employment income.” An automatic extension allows you to file your return (and fund a SEP) until Aug. 16 of this year, while a further extension to Oct. 15 may be requested. Deductible SEP contributions can be 25% of your income, or up to $40,000.

Home office deductions. Further deductions may be available to Williams for work he’s doing to renovate and expand his home. “I’m setting up a home office there,” he says, “that will include business-related equipment, such as a high-speed computer line.”

Williams’ tax adviser, Ralph Grant of Grant & Smith L.L.P., an accounting firm in Oakland, California, says that creating a home office may enable Williams to convert some nondeductible outlays such as insurance and repairs to deductible business expenses. “To qualify for home office tax breaks,” says Grant, “part of your home must be used regularly and exclusively for business. You can’t use it for other purposes.” Your home office must be your principal place of business, meaning that’s where you perform the most important part of your work not at another location. Assuming you arrange your affairs so you meet those criteria and you use, say, 10% of your home as an office, you can deduct 10% of your homeowner’s insurance, 10% of your roof repairs, etc.

Business equipment deductions. Besides outfitting his home office, Williams says that he also intends to buy vans for his expanding business and, perhaps, other equipment as well. “This is a good time to buy equipment that you need, as long as you can afford it,” says Grant. “Under Section 179 of the tax code, you can take an immediate deduction for up to $100,000 worth of purchases this year,” says Grant.

However, not all equipment will qualify for this deduction, according to Grant. “Some purchases may have to be depreciated over several years,” he says, “but the 2003 tax law includes a provision that allows 50% bonus depreciation for business equipment. That provision expires soon, so it might pay to act this year.” Mid-year, then, can be a good time to plan what business equipment you intend to purchase at the end of 2004.

Investors May Dote on Dividends
Mid-year also can be a good time for a portfolio review, with an eye toward cutting taxes on investment income. “I’ve increased the amount of dividend-paying stocks I own,” says Andre, naming IBM, GE, and Bank of America among his holdings. “I also own some utilities stocks. The new 15% tax rate on dividend income makes those kinds of investments more appealing.” Dividends are now taxed as lightly as long-term capital gains are taxed, while interest income may be taxed up to 35%.

Investment interest expense. “I buy these stocks on margin,” says Andre. “If they go up in price, the leverage will increase my profits.” Buying stocks with borrowed funds boosts the risks as well as the potential returns, but today’s low interest rates make such a strategy more attractive.

The tax treatment of margin investing is tricky, though. “The interest on margin loans may be tax-deductible,” says Jerry Lerman, managing director, American Express Tax and Business Services in New York. “Such loans can produce investment interest expense, which is deductible up to the amount of net investment income.”

The catch? Dividends that qualify for the 15% maximum rate don’t count as investment income for the investment interest-expense deduction. If your only investment income comes from dividends, you won’t get to deduct the margin interest you pay. On the other hand, if you also have interest income and short-term capital gains, you can deduct margin interest against that income while still getting the bargain 15% tax rate on dividend income and long-term capital gains.

Tax shelters. Other tax-saving investment opportunities might be investigated now, well before year-end. “Some of my clients have done well with low-income housing partnerships as well as oil and gas drilling programs,” says Hall. “Both offer tax benefits to investors, if you work with the right people. But you shouldn’t wait until the end of the year when there is a rush to find tax shelters.” Andre DeBose is among the clients considering such ventures now, says Hall.

THE PUSH TOWARD E-FILING
This year marks the first time that corporations and tax-exempt organizations have the option of filing their annual income tax returns electronically. This new system, which significantly reduces the time needed to file Forms 1120 and 990, provides corporations and tax-exempt organizations with the option to transmit tax return data using a secure Internet connection in place of a modem.

According to a statement released by the Internal Revenue Service, taxpayers and tax professionals can prepare the returns using IRS-approved software developed by one of several software companies. In 2003, corporations filed more than 5.7 million corporate income tax returns (Form 1120) and tax-exempt organizations filed 506,000 annual information returns (the Form 990 series), plus 395,000 automatic extension forms. This year, as of the week of April 15, 2004, more than 48.5 million tax returns have been submitted via the Internet.

“E-filing is the fastest, easiest way to do taxes,” said IRS Commissioner Mark W. Everson in a statement. “There are fewer errors, and taxpayers get their refunds in less than half the time of paper returns.”

As it stands this year, 11 million returns were filed to the IRS from home-based computers, an increase of 21.3% from last year, while tax professionals filed more than 34.2 million returns electronically, a 13.7% increase from last year.

2004 Filing Season Statistics

*In millions to the nearest hundred. Source: Internal Revenue Service.