December 2001
Vol 25 No 4
Whew, this has been quite a year. Over the past 12 months we've had the election SNAFU, political budget wrangles, a bear market plus the bombing that erased trillions of dollars from the market, falling mortgage rates, a new Tax Act, military conflict, job layoffs, and now the Anthrax scare. You'd think that we'd get some kind of respite in this final season of the year. Alas, that isn't going to happen. With billions spent on the war on terrorism, government at all levels is fast running out of money. The only way they can get it back is from the taxpayer!
Bush's tax law provided a little tax relief, but nobody is going to get a free ride out of it. Commencing in 2001, individual tax brackets will drop by .5% with another .5% being subtracted in 2002. The name of the game is to take as many write-offs as possible this year, and to defer income into next year, when there may well be additional rate reductions to help spur the economy.
To accomplish this so late in the year, there are two tried and true last ditch year-end tax strategies that present themselves: The first is to shift income from this year into next year. You can do this by (a) delaying year-end bonuses into next year, (b) holding off billing for any services or products until next year, (c) making maximum payins into deductible retirement plans, (d) reducing pension plan payouts by using the revised lower minimum distributions from retirement plans, (e) putting savings into short term Treasury Notes or CDs to defer interest into next year, (f) and deferring gains until next year by selling Options, and by entering into delayed “Starker” exchanges. When you fail to replace a property, sale proceeds paid out to you in a following year is taxed then.
Earn profits in a C-corporation. It can earn up to $50,000 net and still only be in the 15% income tax bracket. Reduce its income — and yours — by paying for as many employee fringe benefits as possible for you and your family, including reimbursement for medical and educational expenses, transportation and parking, special tools and equipment, key-man term life and health and accident insurance, day care or adult care expenses. etc. It can also provide housing and incidental meals when required by an employment contract to meet the needs of the business. A tax-deductible qualified corporate retirement plan can drastically reduce net taxable corporate earnings by transferring profits into your plan; tax-free to you.
Don't forget State taxes. C-Corporations in low-taxed States can retain their income there and avoid paying taxable dividends and wages that could be taxed to you in a high taxed State. By not paying out dividends or compensation until after the first of the year, profits can be kept out of your 2001 income. If you earn money via any kind of “pass-through” organization such as a Limited Liability Company or Partnership, a Trust, or S-corporation, take maximum allowable deductions at that level rather than at your personal level.
In 2001, businesses can take 6-month's depreciation on personal property bought as late as December 31st. Those who buy big SUV's and Mini-Vans rated at over 6,000 lbs GVW for use in their trade or business can expense up to $24,000 of the cost in 2001 because these are treated as trucks. After you've funded an array of fringe benefits and retirement contributions with earned income, your next strategy would be to avoid 15% payroll taxes by getting the balance of your personal income from passive sources such as interest, rents, royalties, and capital gain.
For example, in lieu of “earning” management fees, an S-corporation could lease rentals at 90% of fair market rents, then sub-lease them for rental profit. As a result, the rental income would pass through to the owner as unearned income, avoiding payroll taxes and any offset against Social Security entitlements. In States where only earned income is taxed, this would reduce State taxes too.
THE BRAVE NEW WORLD OFFERS TAXPAYERS BOTH HOPE AND HAZARD.
One of the eternal verities is that “there's no such thing as a free lunch”. When it comes to income and estate taxes, this has special importance. For several years there have been two mantras uttered by everyone who would reduce taxes and increase after-tax income: Roth IRAs and Section 121 tax-free residence sales. A lot of people have formed so-called “self-directed” Roth IRAs that have been sputtering along since 1997. A few others have been extremely aggressive in the way they have diverted profits to Roth IRAs rather than to taxpayers or tax-paying entities. Indeed, some of the most creative efforts of extremely cagey individuals have been oriented toward piling up wealth inside Roth IRAs where it can continue to compound and grow tax-free income for the future. This could back fire on them.
Let me play Devil's advocate: If I were running the U.S. Treasury Department, I'd want to find some way to trap the most creative tax avoiders into paying high taxes. I'd do this by giving them plenty of rope with which to hang themselves by offering a four-lane paved one-way highway to tax-free wealth. I'd call it a Roth IRA, which promised them an opportunity to create virtually unlimited wealth tax-free. Next, I'd sit back and watch them find ways to skirt the intent of the tax regulations without actually breaking the law while they piled up millions of dollars inside a supposedly tax-free environment.
How would I spring my trap without seeming to have reneged on my deal with them? Oh, I might change the estate laws to make all estates above $1.000,000 taxable in 2011. Or, I might decide that, while Roth IRA distributions might be income tax-free, they would still be subject to the Alternate Minimum Tax. Or, I might just start auditing the complete investment record of the Roth IRA at the point at which the first distribution were made. In these audits, I'd rule that “circumvention” of the law by circuitous complex financial arrangements between Roth IRA beneficiaries and confederates were illegal. Upon discovering these, I'd disallow the Roth IRA back to day-1, and tax all profits, plus penalties, and interest. That would be a fantastic windfall for the U.S. Treasury.
Could this happen? Sure. Will it happen? Beats me; but I wouldn't want to put all of my eggs into a Roth IRA basket when there are still other tax-saving devices and strategies that might be available to me. What might these be? Let's take a look: When it comes to retirement plans, the corporate defined benefit plan offers current annual deductions of up to $170,000 from corporate income for many years in return for making all distributions taxable when withdrawn. For high income wage earners, that might not be such a bad alternative to a Roth IRA.
Charitable Trusts enable a person to avoid tax on profits and on fully depreciated free and clear capital assets while allowing them to continue to grow and compound. They can continue to produce a protected income stream at any age that can continue for two generations before they would pass to a charity. Best of all, no tax needs to be recognized at any level prior to placing these assets into trust. Moreover, at least one Revenue Ruling plus the proposed tax law would permit a charitable trust being funded by a retirement plan without any taxable event being recognized at all. Oh yeah, if the plan were to be funded by tax free bonds, or invest in them, the distributions could also be tax free to the income beneficiary. This is a fantastic device for building a bullet-proof estate, and for funding charitable purposes at the end of the trail.
Last but not least IRC Section 121 that gives a taxpayer the ability to sell a residence and to start living a tax-free lifestyle at any age off the profits. No minimum age limits. No restrictions on self-dealing or unrelated business income. No need to pay off debt. Ability to exchange properties used in trade or business, held for production of income, or for investment into residential property that can be converted to personal use, then sold tax-free every three years or so. Rather than to rely upon a single Roth IRA strategy, it seems far more prudent to avail oneself of all of the devices placed into the tax code and intended for our use to reduce our tax burden by our Congress. Why not start in 2002?
USE FAMILY GIFTS TO REDUCE OVERALL TAX BILLS .
Tax-reduction strategies can span a wide variety of federal tax laws. Taxes include: Income Taxes, Social Security and Medicare Taxes, Excise Taxes, Unemployment Taxes, Estate and Gift taxes, Corporate and Personal Alternate Minimum Taxes, Corporate taxes, Import/Export Taxes and Tariffs, etc. are all related, but quite different in their applications. Each tax system has its own hierarchy of credits, exclusions, exemptions, deductions, allowances, etc. From time to time this mix of taxes can create opportunities for tax reduction. Every time we can avoid one of these taxes we save more money. Let's look at a few examples:
Most kids who earn money will be in the 15% tax bracket. More often than not, their parents will be in the 28% bracket. Suppose a parent paid a kid to work for a family sole proprietorship; it would transfer income taxed at 28% plus 15.3% payroll taxes from the parents to the child to be taxed at 15%. No payroll taxes need be paid. That's a 28.3% tax savings. But that's not all; once the kid has earned his money, the parent can make a gift to the kid's Roth IRA of the lesser of earned income or $2000 each year, and the kid can keep earned income to pay for education, clothing. transportation. insurance, recreation. etc.
Commencing in 2002, $11,000 can be gifted tax-free by anyone to anyone. That means that two parents can gift a child $22,000 per year, each year. Suppose there were two kids in a family, $44,000 could be transferred tax-free between generations. For kids under the age of 14, these gifts should be non-income producing assets such as Options, land, net break-even real estate, tax-free bonds, and non-dividend-paying growth stocks such as Viacom, Microsoft, Cisco, etc. Once the 14th birthday has been reached, the investments could be switched over into leveraged cash flow rental properties, discounted notes, etc. and the income can be used to pay for the kid's personal expenses, or saved to pay for college expenses.
Fully depreciated income-producing rental property can be gifted to retired grandparents to augment their incomes taxed in the 15% bracket. This will take the income out of the high-bracket kid's AGI, and into their parents lower tax brackets. They can then gift the income back to their high-bracket kids tax-free; or used to pay for their grand children's education. Any amount of tuition can be gifted by a grandparent directly to a college or university to pay for grand children's education. When the grandparent goes to the big escrow in the sky, in 2002 they can leave the parent or grandchildren up to $1 million in appreciated property tax-free with the depreciable tax basis stepped up to fair market value.
Shares of family-owned corporations, partnerships, limited liability companies, and trusts can be combined in such a way that as much as 135% of the value can be either inherited or gifted tax-free while control over the assets remains with the donor. This not only gifts assets but also gifts the earning power and income of those assets. The recipient of these assets and income can use the low-taxed income to pay expenses that would have to be paid by their parents out of higher taxed income.
Fully depreciated rental real estate can be leased by a member of the younger or of the older, generation. then sub-leased at a higher rent to an occupant. This will transfer income from a high-bracket parent to a lower-bracket taxpayer, while leaving all of the tax write-offs and un-taxed appreciation in the hands of the parent. At some point in the future, the losses that have been written off at ordinary income tax rates will be taxed at much lower capital gains rates.
Because C-corporations can be taxed on fiscal years that don't conform to calendar years, it is possible to transfer a taxable event, whether the sale of assets or the production of operating income, from the current tax year to a subsequent tax year. By entering into a contract that calls for annual payments, and by timing performance bonuses, this enables both wages and dividends to be paid out in years that best suit the employee's tax strategy. Thus, the corporate owner/employee can have the best of both corporate owner and employee worlds.
MAXIMIZE DEDUCTIONS FROM TAXABLE INCOME.
Starting with the lowest possible taxable adjusted gross income, the second major strategy is to maximize deductions. Standard deduction limits are $7600 for marrieds; plus another $900 for each spouse over 65. For singles, it's $4550; plus $1100 if over 65. Heads of Households deduct $6650; plus $1100 if over 65. Through the use of fringe benefits and business needs, many deductible expenses will have been taken by the business, thus there will be fewer deductions for you to take at personal level. This can make your Standard Deduction a no-cost write-off.
Taxpayers with high home interest payments, State and local taxes, significant unreimbursed medical expenses, and charitable contributions might do well by choosing to itemize deductions. On the average, taxpayers with adjusted gross taxable family income between $30,000 and $50.000 claim about $12.000 in itemized deductions. This climbs to about $15,000 on taxable income between $50,000 and $100,000. Above-average deductions don't necessarily trigger audits, but unusually high expenses should be well documented and explained.
You can alternate between years taking standard deductions in one year, and itemizing deductions the next. To get the most out of itemized deductions, most expenses must exceed 2% of your Adjusted Gross Income (AGI). Casualty losses must exceed 10%. Medical expenses must exceed. 7.5%. Your strategy would be to try to time deductible payments, discretionary medical treatment such as hearing aids and glasses, elective surgery, charitable contributions, and deductible expenses so that you'd be able to take maximum itemized deductions. The following year, you'd take the standard deduction while you “saved up” potential deductions for the following year. This way, over a two year period, you'd pay less taxes.
Here's how to do this: In 2001, you might elect to file a Standard Deduction, so you'd delay making the December interest payment, deductible rental house repairs, insurance payments, real estate and personal property taxes until January 2002. You'd double up on your deductions by accelerating interest, taxes, insurance. repairs into 2002 from 2003, and paying for them prior to 2003. You'd also double up the same way on charitable gifts (to a public charity, or to your own Charitable Remainder Unit Trust) to concentrate them into the year that you chose to itemize deductions. Instead of gifting cash to charity, gift appreciated stocks and deduct the full market value of them while avoiding tax on gain.
Speaking of stocks, and any other capital investment, being willing to hold stocks for long term gain rather than for short term speculation can reduce maximum taxes on gains from 39.6% to 20%. If you gifted stocks to over 14 year-old kids in the 15% bracket, gains would only be taxed at 10%. If you've owned Stocks for 5 years or more taxpayers will only pay 8% and 18% respectively. Remember, when you gift shares of stock to a kid, your holding period is tacked onto his. C-Corporations that earn less than $50,000 are only taxed in the 15% bracket; so stocks contributed to a corporation could be sold with a maximum tax rate of 15%. Taxable gain might be consumed to buy tax-free fringe benefits.
What about losses? You can sell losing stocks, realize the tax-loss benefits, and if you still like them, buy them back after 30 days. If the market keeps dropping, you could wind up with more stocks for less money later. To reap the deductions, first, short term gains and losses netted, then long term gains and losses are netted out; then the totals of these calculations are netted against each other. Any losses can shelter up to $3000 per year of all other income, and any excess loss can be carried forward and used in later years.
Even when you've elected to take the Standard Deduction, you can still deduct alimony, up to $2500 in interest on student loans, job-related moving expenses, and 60% of medical insurance for self-employed people. You can also deduct amounts paid into Keough retirement plans, and for those who are eligible, payments into conventional IRAs. These are in addition to your Standard Deduction.
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