Your 2011 tax return has been filed, or you have properly filed for an extension. In either case, now it’s time to start thinking about important post-filing season activities to save you tax in 2012 and beyond.  A few loose ends may pay dividends if you take care of them sooner instead of later.

Successful filing season

The IRS reported that the 2012 filing season moved along without significant problems. The IRS continued to upgrade its return processing programs and systems.  Early in the filing season, some filers experienced a short delay in receiving refunds but the delay was quickly resolved.  The IRS reported just before the end of the filing season that it had processed nearly 100 million returns and issued 75 million refunds. 

Extensions

Individuals are eligible for an automatic six-month extension until October 15 to file a return. To get the extension, taxpayers must estimate their tax liability and pay any amount due.  When a taxpayer properly files for an extension, he or she avoids the late-filing penalty, generally five percent per month based on the unpaid balance, which applies to returns filed after the April 17 deadline. Any payment made with an extension request will reduce or eliminate interest and late-payment penalties that apply to payments made after April 17. The current interest rate is three percent per year, compounded daily, and the late-payment penalty is normally 0.5 percent per month.

Installment agreements

Installment agreements generally can be set up quickly with the IRS and help to spread out payments to make them more manageable.  In 2012, the IRS increased the threshold for a streamlined installment agreement from $25,000 to $50,000. Installment agreements however, come with some costs.  The IRS charges a fee to set up an installment agreement.  If you cannot pay the full amount within 120 days, the fee for setting up an agreement is:

• $52 for a direct debit agreement;
• $105 for a standard agreement or payroll deduction agreement; or
• $43 for qualified lower income taxpayers.

It’s important to make your scheduled payments timely and in full. The IRS expects you to pay the minimum amount agreed on; you can always pay more if you are able.  If your installment agreement goes into default, the IRS can charge a reinstatement fee.

An installment agreement does not reduce the amount of the taxes, interest, or penalties owed, and penalties and interest will continue to accrue. In determining the amount of the penalty for failure to pay tax, the penalty is reduced from 0.5 percent per month to 0.25 percent per month during any month that an installment agreement for the unpaid tax is in effect.

You must specify the amount you can pay and the day of the month (1st-28th) on which you wish to make your payment each month. The IRS expects to receive your payment on the date you select. The IRS will respond to your request, usually within 30 days, to advise you as to whether your request has been approved or denied, or if more information is needed.

Amended returns

Taxpayers can file an amended return if they find an error, uncover unreported income or discover an item that will generate a deduction. Amended returns are filed on Use Form 1040X, Amended U.S. Individual Income Tax Return, to correct a previously filed Form 1040, Form 1040A, Form 1040EZ, Form 1040NR, or Form 1040NR-EZ. If you are filing to claim an additional refund, wait until you have received your original refund. If you owe additional tax for a tax year for which the filing date has not passed, file Form 1040X and pay the tax by the filing date for that year to avoid penalties and interest. 

Generally, to claim a refund, Form 1040X must be filed within 3 years from the date of your original return or within two years from the date you paid the tax, whichever is later. Returns filed before the due date (without regard to extensions) are considered filed on the due date. Taxpayers must file a separate Form 1040X for each year they are amending.

Targeted penalty relief

This year – for the first time – the IRS offered penalty relief to qualified individuals who were unable to pay their taxes by the April 17 deadline. Unemployed filers and self-employed individuals whose business income dropped substantially can apply for a six-month extension of time to pay, the IRS explained. Eligible taxpayers will not be charged a late-payment penalty if they pay any tax, penalty and interest due by October 15, 2012. Taxpayers qualify if they were unemployed for any 30-day period between January 1, 2011 and April 17, 2012. Self-employed people qualify if their business income declined 25 percent or more in 2011, due to the economy.  However, income limits apply, which excluded many taxpayers from the program.

Records

The IRS advises that taxpayers maintain tax records for three years.  In many cases, especially for individuals with complex returns, records should be kept longer. Our office maintains taxpayer records with the utmost care and confidentiality.

We encourage you to contact us if you have any questions about the end of the 2011 filing season and how your 2011 return can provide a roadmap to tax savings in 2012.

After three days of oral arguments in March, the Supreme Court is deciding the fate of the Pension Protection and Affordable Care Act (PPACA) and its companion law, the Health Care and Education Reconciliation Act (HCERA).  Not only do the new laws impact health care, they contain numerous tax provisions, many of which have yet to take effect.  The Supreme Court may uphold the laws, strike them down in whole or in part, or decide that the case is premature.  The Supreme Court is expected to render its decision in June.  In the meantime, a quick checklist of the tax provisions in the two laws reveals how extensively they impact individuals, businesses and taxpayers of all types.

Challenges

Congress passed, and President Obama signed, the PPACA and HCERA in 2010.  Almost immediately, several states and taxpayers challenged the laws in court.  The lawsuits generally argued that Congress had exceeded its authority by requiring individuals to obtain health insurance.

The cases made their way from federal district courts to the various federal courts of appeal, which reached different conclusions.  One circuit court invalidated the individual mandate; two circuit courts upheld the individual mandate and another circuit court dismissed the challenge on procedural grounds.

Supreme Court grants review

On November 14, 2011, the United States Supreme Court agreed to review the Eleventh Circuit Court’s decision in Florida v. U.S. Department of Health and Human Services.  The Supreme Court stated it would examine four issues: (1) the Constitutionality of the individual mandate; (2) whether the individual mandate is severable from the PPACA; (3) whether the challenge to the individual mandate is barred by the Anti-Injunction Act^; and (4) whether PPACA’s expansion of Medicaid exceeded Congress's authority. The Supreme Court heard oral arguments in the case on March 26-28 in Washington, D.C. 

Individual mandate and penalty

The individual mandate generally requires individuals to maintain minimum essential coverage for themselves and their dependents after 2013. Individuals will be required to pay a penalty for each month of noncompliance, unless they are exempt (such as individuals covered by Medicaid and Medicare).  The PPACA also provides tax incentives to help individuals obtain minimum essential coverage.  Beginning in 2014, individuals with incomes within certain federal poverty thresholds may qualify for a refundable health insurance premium assistance tax credit.  The PPACA also provides for advance payment of the credit.

In Florida v. HHS, the Eleventh Circuit struck down the individual health insurance mandate but did not declare the entire PPACA unconstitutional.  In contrast, the Sixth Circuit held that the individual mandate was a valid exercise of Congress’ power to regulate commerce (Thomas More Law Center v. Obama).  The Court of Appeals for the District of Columbia Circuit also upheld the individual mandate (Mead v. Holder).  The Supreme Court could find the entire PPACA unconstitutional or could find that the individual mandate is severable, thereby preserving other parts of the statute, including various tax provisions.

Tax provisions

While much attention has focused on the individual mandate, the Supreme Court may also decide the fate of many tax provisions in the PPACA and the HCERA. Among the tax provisions potentially affected by the Supreme Court’s decision are:

• Code Sec. 45R small employer health insurance tax credit;

• 3.8 percent Medicare contribution tax on unearned income for higher income taxpayers after 2012;

• Additional 0.9 percent Medicare tax on wages and self-employment income of higher income taxpayers after 2012;

• Increased itemized deduction for unreimbursed medical expenses after 2012;

• Prohibition on over-the-counter medicines being eligible for health flexible spending arrangement (FSA), health reimbursement arrangement (HRA), health savings account (HSA), and Archer Medical Savings Account (MSA) dollars.

• Additional tax on distributions from HSAs and Archer MSAs not used for qualified medical expenses;

• Excise tax on high-dollar health plans after 2017;

• Tax credit for therapeutic discovery projects;

• Annual fees on manufacturers and importers of branded prescription drugs;

• Reporting of employer-provided health coverage on Form W-2;

• Codification of the economic substance doctrine.

Anti-Injunction Act

The Supreme Court could decide that the challenge to the PPACA is premature.  Under the Anti-Injunction Act, a taxpayer must wait to oppose a tax until after it is collected.  The PPACA’s individual mandate and its related penalty do not take effect until 2014.  The Fourth Circuit Court of Appeals found that the penalty amounted to a tax and taxpayers could not challenge the tax until it took effect (Liberty University v. Geithner).

If you have any questions about the tax provisions in the health care reform laws, please contact our office. We will be following developments as they ensue after the Supreme Court issues its decision in June.

Proposals to reform retirement savings plans were highlighted during an April 2012 hearing by the House Ways and Means Committee.  Lawmakers were advised by many experts to move slowly on making changes to current retirement programs that might discourage employers from sponsoring plans for their workers.  Nevertheless, it is clear that Congress wants to make some bold moves in the retirement savings area of the tax law and that likely it will do so under the broader umbrella of general “tax reform.” While tax reform is gaining momentum, it is unlikely to produce any change in the tax laws until 2013 or 2014. Considering that retirement planning necessarily looks long-term into the future, however, now is not too soon to pay some attention to the proposals being discussed.

Testimony

The Chief of Actuarial Issues and Director of Retirement Policy for the American Society of Pension Professionals and Actuaries testified that current federal tax incentives can transform taxable bonuses for business owners into retirement savings contributions that benefit both owners and employees. “This incentive for the business owner to contribute for other employees results in a distribution of tax benefit that is more progressive than the current income tax structure," she observed.

An American Benefits Council representation warned at the hearing that the wisest course for lawmakers is to not enact new laws that would disrupt the success of the current system. Short-term retirement legislation designed to boost tax revenues generally do so by eliminating the existing savings incentives and eroding the amount that workers actually save.

Committee Chairman Dave Camp, R-Mich. questioned whether the large number of retirement plans now existing with their different rules and eligibility criteria leads to confusion, reducing the effectiveness of the incentives in increasing retirement savings. Ranking member Sander Levin, D-Mich., questioned the value of making tax reform-inspired changes to retirement plans. "Tax reform should approach retirement savings incentives with an eye toward strengthening our current system and expanding participation, not as an opportunity to find revenue," Levin said.

JCT report

In advance of the hearing, the Joint Committee on Taxation (JCT) summarized the tax treatment of current-law retirement savings plans and described some recent reform proposals in a report, “Present Law and Background Relating to the Tax Treatment of Retirement Savings” (JCX-32-12). The report highlighted several of the recent proposals on retirement savings:

Automatic enrollment payroll deduction IRA.  President Obama has proposed mandatory automatic enrollment payroll deduction IRA programs.  An employer that does not sponsor a qualified retirement plan, SEP, or SIMPLE IRA plan for its employees (or sponsors a plan and excludes some employees) would be required to offer an automatic enrollment payroll deduction IRA program with a default contribution to a Roth IRA of three percent of compensation. An employer would not be required to offer the program if the employer has been in existence less than two years or has 10 or fewer employees.

Expand the saver's credit.  The Administration has also proposed to make the retirement savings contribution credit, known as the saver's credit, fully refundable and for the saver’s credit to be deposited automatically in an employer-sponsored retirement plan account or IRA to which the eligible individual contributes. In addition, in place of the current credit ranging from 10 percent to 50 percent for qualified retirement savings contributions up to $2,000 per individual, the proposal would provide a credit of 50 percent of such contributions up to $500 (indexed for inflation) per individual.

Consolidate plans.  The JCT also reviewed two retirement proposals from the Bush administration:  Consolidating traditional and Roth IRAs into a single type of account called Retirement Savings Accounts (RSAs) and creating Lifetime Savings Accounts (LSAs) that could be used to save for any purpose with an annual limit for contributions of $2,000. The JCT explained that the tax treatment of RSAs and LSAs would be similar to the current tax treatment of Roth IRAs (contributions would not be deductible, and earnings on contributions generally would not be taxable when distributed). Additionally, the Bush Administration had proposed to consolidate various current-law employer-sponsored retirement arrangements under which individual accounts are maintained for employees and under which employees may make contributions into a single type of arrangement called an employer retirement savings account (ERSA).

The American Society of Pension Professionals and Actuaries (ASPPA) told the Ways and Means Committee that the large number of plans with different rules and criteria does not reduce the effectiveness of the incentives in increasing retirement savings. ”Consolidating all types of defined-contribution type plans into one type of plan would not be simplification,” the ASPPA cautioned. “It would disrupt savings, and force state and local governments and nonprofits to modify their retirement savings plans and procedures.”

Code Sec. 1231 applies to gains and losses from property used in the trade or business and from involuntary conversions. Normally, you have to determine whether property is a capital asset or is ordinary income property. Property generally can’t be both. However, Code Sec. 1231 allows you to “have it” both ways. Any gains are taxed at low capital gains rates (generally 15 percent for 2012), and any losses are treated as ordinary losses, taxable at more favorable ordinary loss rates, and available (without limit) to offset other ordinary income.

Who qualifies?

Code Sec. 1231 gains include:

--Recognized gains on the sale or exchange of property used in the trade or business; and

--Recognized gains from the involuntary or compulsory conversion (into money or other property) of property used in a trade or business, or of property held for more than one year and either used in the trade or business or used in a transaction entered into for profit.

Property used in a trade or business is property that is subject to depreciation and held by the taxpayer for more than one year.

Code Sec. 1231 losses are any recognized loss from a sale, exchange, or conversion of the same categories of property.

A win-win equation

Gains and losses from these transactions are referred to as Code Sec. 1231 gains and Code Sec. 1231 losses. The character of the gain or loss depends on whether Code Sec. 1231 gains exceed Code Sec. 1231 losses for the tax year. If the Code Sec. 1231 gains exceed the Code Sec. 1231 losses, then all of the Code Sec. 1231 gains and losses are treated as long-term capital gains and losses. The result is a net long-term capital gain. This amount can then be netted with other capital gains and losses.

Code Sec. 1231 does not apply to depreciation that must be recaptured as ordinary income under either Code Sec. 1245 (depreciable personal property and certain real property) or Code Sec. 1250 (depreciable real property that is not Code Sec. 1245 property).

If, however, the Code Sec. 1231 losses equal or exceed the Code Sec. 1231 gains, then all of the Code Sec. 1231 gains and losses are treated as ordinary income and losses. The net result is an ordinary loss, which can offset other ordinary income.

The family partnership is a common device for reducing the overall tax burden of family members. Family members who contribute property or services to a partnership in exchange for partnership interests are subject to the same general tax rules that apply to unrelated partners. If the related persons deal with each other at arm's length, their partnership is recognized for tax purposes and the terms of the partnership agreement governing their shares of partnership income and loss are respected.

Interfamily gifts

Because of the tax planning opportunities family partnerships present, they are closely scrutinized by the IRS. When a family member acquires a partnership interest by gift, however, the validity of the partnership may be questioned. For example, a partnership between a parent in a personal services business and a child who contributes little or no services is likely to be disregarded as an attempt to assign the parent's income to the child. Similarly, a purported gift of a partnership interest may be ignored if, in substance, the donor continues to own the interest through his power to control or influence the donee's business decision. When a partnership interest is transferred to a guardian or trustee for the benefit of a family member, the beneficiary is considered a partner only if the trustee or guardian must act independently and solely in the beneficiary's best interest.

Capital or services

The determination of whether a person is recognized as a partner depends on whether capital is a material income-producing factor in the partnership. Any person, including a family member, who purchases or is given real ownership of a capital interest in a partnership in which capital is a material income-producing factor is recognized as a partner automatically. If capital is not a material income-producing factor (for example, if a partnership derives most income from services, a family member is not recognized as a partner unless all the facts and circumstances show a good faith business purpose for forming the partnership.

If the family partnership is recognized for tax purposes, the partnership agreement generally governs the partners' allocations of income and loss. These allocations are not respected, however, to the extent the partnership agreement does not provide reasonable compensation to the donor for services he renders to the partnership or allocates a disproportionate amount of income to the donee. The IRS can re-allocate partnership income between the donor and donee if these requirements are not met.

Investment partnerships

The general rule for determining gain recognition for marketable securities does not apply to the distribution of marketable securities by an investment partnership to an eligible partner. An investment partnership is a partnership that has never been engaged in a trade or business (other than as a trader or dealer in the certain specified investment-type assets) and substantially all the assets of which have always consisted of certain specified investment-type assets (which do not include, for example, interests in real estate or real estate limited partnerships).

If a family limited partnership (FLP) qualifies as an investment partnership, the FLP could redeem the partnership interest of an eligible partner with marketable securities without the recognition of any gain by the redeemed partner. To qualify, substantially all the assets of the FLP must always have consisted of the eligible investment assets, and the holding of even totally passive real estate interests (real estate that does not constitute a trade or business), for instance, must be kept to a minimum. In addition, any eligible partner must have contributed only the specified investment assets (or money) in exchange for his or her partnership interest.

As an individual or business, it is your responsibility to be aware of and to meet your tax filing/reporting deadlines. This calendar summarizes important tax reporting and filing data for individuals, businesses and other taxpayers for the month of May 2012.

May 2

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates April 25–27.

May 4

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates April 28–May 1.

May 9

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 2–4.

May 10

Employees who work for tips. Employees who received $20 or more in tips during April must report them to their employer using Form 4070.

May 11

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 5–8.

May 16

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 9–11.

May 18

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 12–15.

May 23

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 16–18.

May 25

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 19–22.

May 31

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 23–25.

June 1

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 26–29.

Whether for a day, a week or longer, many of the costs associated with business trips may be tax-deductible. The tax code includes a myriad of rules designed to prevent abuses of tax-deductible business travel. One concern is that taxpayers will disguise personal trips as business trips. However, there are times when taxpayers can include some personal activities along with business travel and not run afoul of the IRS.

Business travel

You are considered “traveling away from home” for tax purposes if your duties require you to be away from the general area of your home for a period substantially longer than an ordinary day's work, and you need sleep or rest to meet the demands of work while away. Taxpayers who travel on business may deduct travel expenses if they are not otherwise lavish or extravagant. Business travel expenses include the costs of getting to and from the business destination and any business-related expenses at that destination.

Deductible travel expenses while away from home include, but are not limited to, the costs of:

• Travel by airplane, train, bus, or car to/from the business destination.
• Fares for taxis or other types of transportation between the airport or train station and lodging, the lodging location and the work location, and from one customer to another, or from one place of business to another.
• Meals and lodging.
• Tips for services related to any of these expenses.
• Dry cleaning and laundry.
• Business calls while on the business trip.
• Other similar ordinary and necessary expenses related to business travel.

Business mixed with personal travel

Travel that is primarily for personal reasons, such as a vacation, is a nondeductible personal expense. However, taxpayers often mix personal travel with business travel. In many cases, business travelers may able to engage in some non-business activities and not lose all of the tax benefits associated with business travel.

The primary purpose of a trip is determined by looking at the facts and circumstances of each case. An important factor is the amount of time you spent on personal activities during the trip as compared to the amount of time spent on activities directly relating to business.

Let’s look at an example. Amanda, a self-employed architect, resides in Seattle. Amanda travels on business to Denver. Her business trip lasts six days. Before departing for home, Amanda travels to Colorado Springs to visit her son, Jeffrey. Amanda’s total expenses are $1,800 for the nine days that she was away from home. If Amanda had not stopped in Colorado Springs, her trip would have been gone only six days and the total cost would have been $1,200. According to past IRS precedent, Amanda can deduct $1,200 for the trip, including the cost of round-trip transportation to and from Denver.

Weekend stayovers

Business travel often concludes on a Friday but it may be more economical to stay over Saturday night and take advantage of a lower travel fare. Generally, the costs of the weekend stayover are deductible as long as they are reasonable. Staying over a Saturday night is one way to add some personal time to a business trip.

Foreign travel

The rules for foreign travel are particularly complex.  The amount of deductible travel expenses for foreign travel is linked to how much of the trip was business related.  Generally, an individual can deduct all of his or her travel expenses of getting to and from the business destination if the trip is entirely for business.

In certain cases, foreign travel is considered entirely for business even if the taxpayer did not spend his or her entire time on business activities. For example, a foreign business trip is considered entirely for business if the taxpayer was outside the U.S. for more than one week and he or she spent less than 25 percent of the total time outside the U.S. on non-business activities. Other exceptions exist for business travel outside the U.S. for less than one week and in cases where the employee did not have substantial control in planning the trip.

Foreign conventions are especially difficult, but no impossible, to write off depending upon the circumstances. The taxpayer may deduct expenses incurred in attending foreign convention seminar or similar meeting only if it is directly related to active conduct of trade or business and if it is as reasonable to be held outside North American area as within North American area.

Tax home

To determine if an individual is traveling away from home on business, the first step is to determine the location of the taxpayer’s tax home. A taxpayer’s tax home is generally his or her regular place of business, regardless of where he or she maintains his or her family home. An individual may not have a regular or main place of business. In these cases, the individual’s tax home would generally be the place where he or she regularly lives.  The duration of an assignment is also a factor. If an assignment or job away from the individual’s main place of work is temporary, his or her tax home does not change. Generally, a temporary assignment is one that lasts less than one year.

The distinction between tax home and family home is important, among other reasons, to determine if certain deductions are allowed. Here’s an example.

Alec’s family home is in Tucson, where he works for ABC Co. 14 weeks a year.  Alec spends the remaining 38 weeks of the year working for ABC Co. in San Diego. Alec has maintained this work schedule for the past three years. While in San Diego, Alec resides in a hotel and takes most of his meals at restaurants.  San Diego would be treated as Alec’s tax home because he spends most of his time there. Consequently, Alec would not be able to deduct the costs of lodging and meals in San Diego.

Accountable and nonaccountable plans

Many employees are reimbursed by their employer for business travel expenses. Depending on the type of plan the employer has, the reimbursement for business travel may or may not be taxable. There are two types of plans: accountable plans and nonaccountable plans.

An accountable plan is not taxable to the employee. Amounts paid under an accountable plan are not wages and are not subject to income tax withholding and federal employment taxes. Accountable plans have a number of requirements:

• There must be a business connection to the expenditure. The expense must be a deductible business expense incurred in connection with services performed as an employee. If not reimbursed by the employer, the expense would be deductible by the employee on his or her individual income tax return.

• There must be adequate accounting by the recipient within a reasonable period of time. Employees must verify the date, time, place, amount and the business purpose of the expenses.

• Excess reimbursements or advances must be returned within a reasonable period of time.

Amounts paid under a nonaccountable plan are taxable to employees and are subject to all employment taxes and withholding.  A plan may be labeled an accountable plan but if it fails to qualify, the IRS treats it as a nonaccountable plan. If you have any questions about accountable plans, please contact our office.

As mentioned, the tax rules for business travel are complex. Please contact our office if you have any questions.

You have carefully considered the multitude of complex tax and financial factors, run the numbers, meet the eligibility requirements, and are ready to convert your traditional IRA to a Roth IRA. The question now remains, however, how do you convert your IRA?

Conversion basics

A conversion is a penalty-free taxable transfer of amounts from a traditional IRA to a Roth IRA. You can convert part or all of the money in your regular IRA to a Roth. When you convert your traditional IRA to a Roth, you will have to pay income tax on the amount converted. However, a traditional IRA may be converted (or rolled over) penalty-free to a Roth IRA as long as you meet the requirements for conversion, including adjusted gross income (AGI) limits in effect until 2010. You should have funds outside the IRA to pay the income tax due on the conversion, rather than taking a withdrawal from your traditional IRA to pay for it - those withdrawals are subject to an early withdrawal penalty and they cannot be put back at a later time to continue to accumulate in the tax-free environment of an IRA.

Big news for 2010 and beyond

Beginning in 2010, you can convert from a traditional to a Roth IRA with no income level or filing status restrictions. For 2008, Roth IRAs are available for individuals with a maximum adjusted gross income of $116,000 ($169,000 for joint filers and heads of household). These income limits have prevented many individuals from establishing or converting to a Roth IRA. Not only is the income limitation eliminated after 2009, taxpayers who convert to a Roth IRA in 2010 can recognize the conversion amount in adjusted gross income (AGI) ratably over two years, in 2011 and 2012.

Example. You have $14,000 in a traditional IRA, which consists of deductible contributions and earnings. In 2010, you convert the entire amount to a Roth IRA. You do not take any distributions in 2010. As a result of the conversion, you have $14,000 in gross income. Unless you elect otherwise, $7,000 of the income is included in income in 2011 and $7,000 is included in income in 2012.

Conversion methods

There are three ways to convert your traditional IRA to a Roth. Generally, the conversion is treated as a rollover, regardless of the conversion method used. Any converted amount is treated as a distribution from the traditional IRA and a qualified rollover contribution to the Roth IRA, even if the conversion is accomplished by means of a trustee-to-trustee transfer or a transfer between IRAs of the same trustee.

1. Rollover conversion. Amounts distributed from a traditional IRA may be contributed (i.e. rolled over) to a Roth IRA within 60 days after the distribution.

2. Trustee-to-trustee transfer. Amounts in a traditional IRA may be transferred in a trustee-to-trustee transfer from the trustee of the traditional IRA to the trustee of the Roth IRA. The financial institution holding your traditional IRA assets will provide directions on how to transfer those assets to a Roth IRA that is maintained with another financial institution.

3. Internal conversions. Amounts in a traditional IRA may be transferred to a Roth IRA maintained by the same trustee. Conversions made with the same trustee can be made by redesignating the traditional IRA as a Roth IRA, in lieu of opening a new account or issuing a new contract. As with the trustee-to-trustee transfer, the financial institution holding the traditional IRA assets will provide instructions on how to transfer those assets to a Roth IRA. The transaction may be simpler in this instance because the transfer occurs within the same financial institution.

Failed conversions

A failed conversion has significant negative tax consequences, and generally occurs when you do not meet the Roth IRA eligibility or statutory requirements; for example, your AGI exceeds the limit in the year of conversion or you are married filing separately (note: as mentioned, the AGI limit for Roth IRAs will no longer be applicable beginning in 2010).

A failed conversion is treated as a distribution from your traditional IRA and an improper contribution to a Roth IRA. Not only will the amount of the distribution be subject to ordinary income tax in the year of the failed conversion, it will also be subject to the 10 percent early withdrawal penalty for individuals under age 59 1/2, (unless an exception applies). Moreover, the Tax Code imposes an additional 6 percent excise tax each year on the excess contribution amount made to a Roth IRA until the excess is withdrawn.

Caution - financial institutions make mistakes

The brokerage firm, bank, or other financial institution that will process your IRA to Roth IRA conversion can make mistakes, and their administrative errors will generally cost you. It is imperative that you understand the process, the paperwork, and what is required of you and your financial institution to ensure the conversion of your IRA properly and timely. Our office can apprise you of what to look out for and what to require of the financial institutions you will deal with during the process.

Determining whether to convert your traditional IRA to a Roth IRA can be a complicated decision to make, as it raises a host of tax and financial questions. Our office can help you determine not only whether conversion is right for you, but what method is best for you, too.

In a period of declining stock prices, tax benefits may not be foremost in your mind. Nevertheless, you may be able to salvage some benefits from the drop in values. Not only can you reduce your taxable income, but you may be able to move out of unfavorable investments and shift your portfolio to investments that you are more comfortable with.

First, you should keep in mind that gain and loss on a sale of stock or mutual fund shares depends on the fair market value of the shares when sold or disposed of, compared to the cost basis of the stock. Your investments may have lost substantial value over recent periods. Nevertheless, if the stock's value when sold is higher than the basis, you still have a gain.

Example. You purchased X Corp stock in 2004, when it cost $5. At the end of 2007, the stock is worth $12. In November, 2008, you sell the stock when its value is $8 a share. Even though your investment has declined in value by 33 percent, you have a gain of $3 a share on the sale ($8 sales price less $5 cost).

The same tax-basis situation that may cause capital gain on the sale of shares that have dropped significantly in value over the past year also is causing many owners of mutual funds that have declined in value to be surprised with a capital gains distribution notice from their fund managers. If you own the mutual fund shares at the time of the capital gain distribution date, you must recognize the gain. Of course, that gain may be netted against your losses from stock or other capital asset sales.

If you realize a profit on a stock sale, the long-term capital gains tax is a maximum of 15 percent, while taxes on wages and other ordinary income can be taxed as high as 35 percent. For taxpayers in the 10 or 15 percent rate brackets, there is no capital gains tax. These reduced capital gains rates are scheduled to expire after 2010. Short-term capital gains (investments held for one year or less) are taxed at ordinary income rates up to 35 percent.

Capital losses can offset capital gains and ordinary income dollar for dollar. Capital gains can be offset in full, whether short-term or long-term. Ordinary income can be offset up to $3,000. If net capital losses (capital losses minus capital gains) exceed $3,000, the excess can be carried forward without limit and can offset capital gains and $3,000 of ordinary income in each subsequent year.

Because a capital loss can offset income taxed at the 35 percent rate, it can be advantageous to sell stock that yields capital gains in one year, while delaying the realization of capital losses until the following year.

Example. Mary has two assets. One asset would yield a $6,000 long-term capital loss when sold. The other would yield a $6,000 long-term capital gain. If Mary sells both assets in the same year, she has a net capital gain of zero. If she realizes the gain in 2008 and the loss in 2009 (by selling the assets in different years), she will increase her 2008 taxes by a maximum of $900 ($6,000 X 15 percent), but will reduce her taxes in 2009 and 2010 by a maximum of $2,100 ($3,000 X 35 percent X 2 years). She will reduce her taxes by $1,200 merely by shifting the timing of the sales.

Worthless securities. You can write off the cost of totally worthless securities as a capital loss, but cannot take a deduction for securities that have lost most of their value from stock market fluctuations or other causes if you still own them and they still have a recognizable value. You do not have to sell, abandon or dispose of the security to take a worthless stock deduction, but worthlessness must be evidenced by an identifiable event. An event includes cessation of the corporation's business, commencement of liquidation, actual foreclosure and bankruptcy. Securities become worthless if the corporation becomes worthless, even if the corporation has not dissolved, liquidated or ceased doing business.

If you would like to discuss these issues, please contact our office. We can help you consider your options.

Nonbusiness creditors may deduct bad debts when they become totally worthless (i.e. there is no chance of its repayment). The proper year for the deduction can generally be established by showing that an insolvent debtor has not timely serviced a debt and has either refused to pay any part of the debt in the future, gone through bankruptcy, or disappeared. Thus, if you have loaned money to a friend or family member that you are unable to collect, you may have a bad debt that is deductible on your personal income tax return.

The fact that the debtor is a family member or other related interest does not preclude you from taking a bad debt deduction, provided that the debt was bona fide and that worthlessness has been established. A direct or indirect transfer of money between family members may create a bona fide debt eligible for the bad debt deduction. However, these transactions are closely scrutinized to determine whether the transfer is a bona fide debt or a gift.

Bona-fide debt and other requirements for deductibility

You may only take a bad debt deduction for bona-fide debts. A bona-fide debt is a debt arising from a debtor-creditor relationship based on a valid and enforceable obligation to repay a fixed or determinable sum of money. You must also have the present intention to seek repayment of the debt. Additionally, for a bad debt you must also show that you had the intent to make a loan, and not a gift, at the time the money was transferred. Thus, there must be a true creditor-debtor relationship.

Moreover, nonbusiness bad debts are only deductible in the year they become totally worthless (partially worthless nonbusiness bad debts are not deductible).

To deduct a bad debt, you must also have a basis in it, which means that you must have already included the amount in your income or loaned out your cash (for example, if your spouse has not paid court-ordered child support, you can not claim a bad debt deduction for the amount owed as this amount was not previously included in your gross income).

Reporting bad debts

You can deduct nonbusiness bad debts as short-term capital losses on Schedule D of your Form 1040. On Schedule D, Part I, Line 1, enter the debtor's name and "statement attached" in column (a). Enter the amount of the bad debt in parentheses in column (f). If you are reporting multiple bad debts, use a separate line for each bad debt. For each bad debt, attach a statement to your return containing the following:

•  A description of the debt, including the amount and date it became due;
• The name of the debtor, and any business or family relationship between you and the debtor:
• The efforts you made to collect the debt; and
• An explanation of why you decided the debt was worthless (for example, you can show the debtor has declared bankruptcy or is insolvent, or that collection efforts such as through legal action will not likely result in the debt being paid).

If you did not deduct a bad debt on your original income tax return for the year it became worthless, you can file a refund claim or a claim for a credit due to the bad debt. You must use Form 1040X to amend your return for the year the debt became worthless. It must be filed with 7 years from the date your original return for that year had to be filed, or 2 years from the date you paid the tax, whichever is later.

Note. If you deduct a bad debt and in a later year collect all or part of the money owed, you may have to include this amount in your gross income. However, you can exclude from your gross income the amount recovered up to the amount of the deduction that did not reduce your tax in the year you deducted the debt.

Contributions to political campaigns are nondeductible. Nondeductible campaign contributions include, for example, contributions to pay for campaign expenses as well as contributions to pay for a candidate's personal expenses while the candidate is campaigning. The line sometimes gets gray, however, when a contribution is being made for a charitable purpose that is being sponsored by a political candidate or is being made to a charity that also appears to be endorsing a political candidate as opposed to a particular position within the public discourse.

Nondeductible contributions and expenses

Admission prices to political dinners and inaugural events, such as balls, galas, parades or concerts, as well as advertising in convention programs and other publications may be nondeductible if the proceeds "inure to the benefit" of a political party or candidate. Proceeds "inure to the benefit" of a political party when the party has the ability to spend any part of the money on the types of expenses enumerated above, or the ability to spend any part of the proceeds even if the money is restricted to a particular purpose that is unrelated to the election of a specific candidate. Proceeds "inure to the benefit" of a candidate if the money can be used, directly or indirectly, to further the selection, nomination or election of the candidate to office. It doesn't matter in that case that the expense (for example, advertising in a dinner program) also furthers the business of the contributor.

Example. The Libertarian Party holds a dinner to raise money for a voter registration drive and a voter education program. Even though the proceeds of the dinner cannot be used for any purpose that is related to the election of specific candidates to public office, the proceeds still inure to the benefit of the Libertarian Party and a taxpayer cannot deduct the costs of any tickets to the dinner that the taxpayer purchases.

Deductible nonpartisan or impartial election expenses

On the other hand, expenses that support certain nonpartisan and impartial election campaign programs may be deductible. Expenses that are paid or incurred by a taxpayer engaged in a trade or business for contributions that support certain nonpartisan or impartial election programs are deductible. Examples of expenses a taxpayer may deduct include:

• Expenses incurred in supporting a debate that gives all candidates for the same public office an equal opportunity to present themselves to the public, provided the expenses are related to a taxpayer's expected future patronage and other otherwise deductible trade or business expenses;
• Expenses incurred in holding an impartial debate for candidates for public office sponsored by the taxpayer and wherein the taxpayer's name is read before and after the debate;
• Expenses in connection with a voter registration drive, even though polls indicate that those who are registered in the drive would more likely support a particular candidate.

Education continues to become increasingly expensive. The Tax Code provides a variety of significant tax breaks to help pay for the rising costs of education, from elementary and secondary school to college. Some people are surprised at what is available these days, as the dust settles on tax rules that have been in transition now for a number of years. A good place to start educating yourself on these education-related tax incentives - to help yourself or a member of your family better tackle the rising expense of education - is right here.

Hope scholarship and Lifetime Learning credits

The Hope (temporarily enhanced and renamed the "American Opportunity Tax Credit" for 2009 and 2010 by the American Recovery and Reinvestment Act of 2009) and Lifetime Learning credits can be claimed for qualified tuition and fees paid by an individual for his or her (or a spouse's or dependent's) enrollment or attendance at any college, university, vocational school or postgraduate school. The American Opportunity Tax Credit, just like the Hope credit, and Lifetime Learning credit can not both be taken for the same student in the same year.

If you pay the qualified education expenses of more than one student in the same year, however, you can choose to take the credits on a per-student for that year. Expenses that do not count towards the Lifetime Learning credit are those incurred to purchase books, supplies and other equipment, and charges and fees associated with meals and lodging. However, the American Opportunity Tax Credit can be claimed for course materials for 2009 and 2010 only.

Moreover, the American Opportunity Tax Credit (unlike the Hope credit) is available for expenses incurred during all four years of college, as provided under the 2009 Recovery Act. The Hope credit is only available for the first two years of college). However, the Lifetime Learning credit can be claimed for all years of postsecondary school (as well as for courses to acquire or improve job skills). In effect, the Lifetime Learning credit can pick up where the Hope credit left off.

The maximum American Opportunity Credit that can be claimed in 2009 and 2010 is $2,500 (previously $1,800 under the Hope credit) of qualified education expenses per student. Under the new credit, the maximum $2,500 per year would be allowed on $4,000 in qualifying payments (100 percent of the first $2,000 and 25 percent of the next $2,000).

For 2009 and 2010, the American Opportunity Tax Credit begins to phase-out when modified adjusted gross income (MAGI) reaches $80,000 for individuals (and $160,00 for joint filers). For 2009, the amount of the Lifetime learning credit phases out for individuals when MAGI reaches $50,000 for individuals and $100,00 for joint filers.

Coverdell Education Savings accounts

Individuals can contribute up to $2,000 a year to a Coverdell Education Savings account, which is established to help pay for the costs of education of an account beneficiary. A beneficiary is someone who is under age 18 or with special needs.

Although contributions to a Coverdell account are not deductible, earnings grow tax-free, and distributions are also tax free if used for qualified education expenses, including tuition and fees, required books, supplies and equipment, as well as qualified expenses for room and board. The account can help pay for the costs of attending an elementary or secondary school, whether public, private or religious, as well as a college or university.

As with the education credits, there are contribution limits based on the taxpayer/contributor's modified AGI.  

Student loan interest

Eligible individuals can take an above-the-line deduction for up to $2,500 of interest paid on student loans used to pay for the cost of attending any college, university, vocational school, or graduate school. A student loan, for purposes of the deduction, is a loan you took out and is designated solely to pay your (or your spouse's or dependent's) qualified education expenses. For example, if you take out a home equity loan to pay for college tuition, the interest may be deductible as mortgage interest, but it is not considered above-the-line interest for a student loan since the lender did not specifically restrict the proceeds to education expenses.

Good news on student loan interest, however, is that qualified education expenses in this case include not only tuition and fees, but also room and board, books, supplies and equipment, and other necessary expenses such as transportation. Interest paid on a loan that is made to you by a related person, such as parents or grandparents, or from a qualified employer plan do not qualify for the deduction.

The deduction is available regardless of whether or not you itemize. For 2009, the amount of the deduction begins to phase out when an individual's modified AGI exceeds $60,000 a year (or $120,000 for married couples filing jointly). The deduction is completely eliminated once an individual's modified AGI reaches $75,000 (or $150,000 for joint filers). For all other taxpayers, the deduction phases out when AGI reaches $60,000 (and is eliminated completely at AGI of $75,000). If you are claimed as a dependent on another's tax return, you can not take the deduction, however.

IRA and 401(k) withdrawals for education expenses

Generally, if you take a distribution from your IRA before you reach age 59 1/2, you must pay a 10 percent additional tax on the early distribution, as well as income tax on the amount distributed. This applies to any IRA you own, whether it is a traditional IRA, a Roth IRA or a SIMPLE IRA. However, you can take a distribution from your IRA before you reach age 59 1/2 and not be subject to the 10 percent additional tax, if the distribution is used to pay the qualified education expenses for:

• Yourself;
• Your spouse; or
• Your or your spouse's child, grandchild or foster child.

Qualified education expenses include tuition, fees, books, supplies, and equipment required for enrollment or attendance at any college, university, vocational school or other post-secondary educational institution. In addition, if the student is at least a part-time student, room and board are generally qualified education expenses, subject to certain limitation.

If you have a 401(k) plan that allows "hardship withdrawals" to be taken to pay for certain higher education expenses, such as tuition and other education expenses, you may consider taking such a distribution to pay for the education expenses for yourself, or your spouse or your children.  

Section 529 college savings plans

An often touted way to pay for college is through a state college savings plan (aka Section 529 plans, or qualified tuition plans). Section 529 plans allow you to save money, tax-free, to pay for qualified education expenses for college. Although contributions are not deductible for federal tax purposes, many states allow residents to deduct contributions on their state return. Moreover, distributions from a 529 plan are tax-free unless the amount distributed is greater than the account beneficiary's adjusted qualified education expenses. Qualified education expenses include amounts paid for tuition, fees, books, supplies and equipment, as well as reasonable costs of room and board for individuals are at least part-time students.

For 2009 and 2010, beneficiaries of qualified tuition plans can use tax-free distributions to pay for computers and computer technology, including internet access. This is courtesy of the American Recovery and Reinvestment Act of 2009.

Special needs education

The cost for a mentally or physically handicapped individual to attend a special school may be deductible as a medical expense if the principal reason for the individual attending the school is to help overcome or alleviate his or her disability. To qualify for the deduction, the individual does not have to attend a "special school." According to the IRS, the costs of a special education program at any school may be deductible if the program is primarily targeted to the individual's disability. Other deductible medical expenses may include the costs of transportation for the special education, summer school, tutoring, and meals and lodging at the school.

However, remember that medical expenses are only deductible to the extent they exceed 7.5 percent of your income, as an itemized deduction. Individuals with special needs children might also consider Coverdell Education Savings accounts as a vehicle for saving and paying for their children's special education expenses.

Private secondary and nursery school expenses

Private secondary expenses are generally not deductible. Furthermore, the IRS has ruled that any expenses allocated to high school tuition related to advance-placement college credit courses are still considered secondary tuition expenses and will not be counted toward the Hope or Lifetime learning credits.

"After-school" or "extended-day" programs, however, may be deductible if taken toward the child and dependent care credit for a child under age 13 to enable both spouses to work.  Expenses incurred to send a child to nursery school, pre-school or similar programs for children below the kindergarten level qualify fully for the child and dependent care credit without any requirement to separate by time or otherwise the educational portion of the expenses from the child care expenses.

The child and dependent care tax credit is a popular credit that, in part, enables you and your spouse (if married) to reduce your taxes by the cost of certain qualifying expenses you incur to have someone care for your child or childrenwho are under the age of 13 so that you can work or look for work. For 2009, you can generally claim up to $3,000 of expenses paid in the year for one qualifying individual, or $6,000 for two or more qualifying individuals, under the dependent and child care credit. Additional income and eligibility limitations apply.

If you have any questions on how these rules apply to your education expenses, please do not hesitate to call our offices.

To ease the pain of the ever-escalating costs of healthcare, many employers provide certain tax-driven health benefits and plans to their employees. To help employers understand the differences and similarities among three popular medical savings vehicles - health savings accounts (HSAs), flexible spending accounts (FSAs) and health reimbursement arrangements (HRAs) - here's an overview.

Health Savings Accounts (HSAs)

HSAs are relatively new. An HSA is a tax-exempt trust or custodial account that is established exclusively to pay for (or reimburse) the qualified medical expenses of the account holder (typically an employee), a spouse or dependents such as children. Individuals get to take an above-the-line deduction for HSA contributions, while employer contributions to an employee's HSA are neither included in the employee's gross income nor subject to employment taxes. HSA earnings grow tax-free and distributions to pay for qualified medical expenses are also tax-free.

For 2008, a deduction may be taken up to $2,900 by individuals with self-only coverage and $5,800 by individuals with family coverage. And, individuals age 55 or older may make additional "catch-up" contributions to an HSA.

HSA contributions in an account carry over from year to year until the employee uses them. HSAs are also portable, meaning that an employee can take their funds when they leave or change jobs.

To be eligible for an HSA, an individual must generally:

• Have a high deductible health plan (HDHP);
• Have no other health coverage except for certain types of permitted coverage (for example, coverage for accidents, disability, dental and vision care, and long-term care);
• Not be enrolled in Medicare; and
• Not be able to be claimed as a dependent on another person's tax return.

HDHPs feature higher annual deductibles than other traditional health plans. For 2008, the minimum HDHP deductible is $1,100 for self-only coverage, and $2,200 for family coverage. HSA annual contributions, however, are not limited to the annual deductible under an HDHP.

Flexible Spending Arrangements (FSAs)

An FSA is an employer-provided benefit program that reimburses employees for specified expenses as they are incurred. Employees must first incur and substantiate the expense before it is reimbursed by the employer. FSAs are also known as "cafeteria plans" or "Section 125 plans" because they are allowed under Code Sec. 125 of the Internal Revenue Code. An FSA allows employees to contribute before-tax dollars to the account to be used to reimburse health care costs. Employers can also contribute to an employee's FSA. Generally, distributions may only be made to reimburse an employee for qualified medical expenses. They generally cannot be carried forward from year to year; specific "use-it-or-lose-it" rules apply.

Funds set aside in an FSA, typically through a voluntary salary reduction agreement, are not included in an employee's gross income or subject to employment taxes (with an exception for employer contributions used to pay for long-term care insurance). Withdrawals from an FSA are tax-free if used for qualified medical expenses. Employees can also withdraw funds from their account to pay for qualified medical expenses even if they have not yet placed the funds in the FSA.

Health Reimbursement Arrangements (HRAs)

An HRA is a type of FSA in which an employer sets aside funds to reimburse employees for qualified medical expenses up to a maximum dollar amount. Employer HRA contributions are not included in employees' gross income or subject to employment taxes. Additionally, employers get to deduct amounts contributed to employees' HRAs. HRAs can only be established and funded by an employer, and can be offered together with other employer-provided health benefits. Self-employed individuals are not eligible for HRAs.

Generally, there is no limit on the amount an employer can contribute to an employee's HRA, and any unused amounts in an HRA can be carried forward to later years. HRAs, however, are not portable and therefore do not follow employees if they change employment.

Distributions from HRAs can only be used to pay for qualified medical expenses that an employee has incurred on or after the date he or she enrolled in the HRA. If a distribution is made to pay for non-qualified medical expenses, those amounts are included in the employee's gross income. Moreover, distributions made to someone other than the employee, their spouse or dependents are taxable income.

If you need further analysis of which of these health-benefit plans may be right for you, and your employees if applicable, please call us.

The flagging state of the economy has left many individuals and families to cope with rising gas prices and food costs, struggle with their mortgage and rent payments, and manage credit card debt and other common monthly bills. Whether individuals are contemplating how to pay off their credit card or obtain a mortgage amid the "credit crunch" and "economic downturn," many people may be considering alternative sources of financing to reach their goals, including the tapping of a retirement account.

You can generally withdraw funds from your 401(k) three ways: through regular distributions, hardship withdrawals or plan loans. Many employers have adopted 401(k) plan provisions that allow employees to borrow money from their retirement account. Although borrowing from your 401(k) may be an option, there are several important considerations you should take into account before tapping your retirement fund.

The basics of borrowing from your 401(k) plan

The amount that you can borrow from a 401(k) plan is limited to 50 percent of the value of your vested benefit or $50,000, whichever amount is less. However, you can take a loan up to $10,000 even if it is more than one-half of the present value of your vested accrued benefit. Interest on a 401(k) plan loan is not deductible. Despite withdrawing funds from your 401(k) through a plan loan, you will remain vested in your account, subject to your obligation to repay the loan.

If certain requirements are not met, a loan from your 401(k) plan will be treated as a premature distribution for tax purposes, subjecting you to current income tax at ordinary rates plus a 10 percent early withdrawal penalty on the amount distributed, certain requirements must be met. You must repay a loan from your 401(k) within five years, subject to only one exception for a loan used to make a first-time home purchase (a principal residence, not a vacation or secondary home). This "residence exception" allows for a loan term as long as 30 years.

Loan repayments must be made at least every quarter, and are generally automatically deducted from your paycheck. If you are unable to repay the loan and default, the IRS treats the outstanding loan balance as a premature distribution from your 401(k), subject to income tax and the 10 percent early withdrawal penalty. Additionally, most plan terms require that you repay the loan within 60 days if you leave or lose your job.

Drawbacks to borrowing from your 401(k)

Before you dip into your 401(k), you need to be aware of the many disadvantages to taking money from your retirement savings. First, and foremost, many plans contain provisions that prohibit you, and your employer, from making contributions to your 401(k) until you repay the loan or for up to 12 months after the distribution. This is a critical disadvantage to borrowing money from your 401(k) because you are not saving for retirement during the time you are repaying the loan, which may take up to five years, or for the year in which contributions are prohibited. This not only means that you are not saving for retirement for a substantial period, you are also not earning a return on the money you could have contributed albeit for the suspension.

It is imperative that you consider the effects of suspended contributions and the lost earnings and tax-free compounding you could have earned on the money you borrowed from your 401(k). And, as previously discussed, if you default and are unable to pay the loan balance, the outstanding amount is treated by the IRS as a premature distribution and subject to income tax at your ordinary tax rate as well as a 10 percent early withdrawal penalty. Additionally, the maximum contribution you will be allowed to make in the year following the suspension will be reduced by the amount contributed in the prior year.

Another point to consider: the money you borrow will only earn the interest you pay on the loan. Typically, on a 401(k) plan loan, administrators use an interest rate of one to two percentage points above prime interest rates. While paying a lower interest rate to yourself may be more favorable then paying a higher interest rate to a bank, you aren't necessarily earning money, especially considering that the interest you pay on the loan could be significantly lower than the potential earnings you could be making if the money remained in your account.

Potential double taxation

In fact, the interest you pay on the loan is money taken from your paycheck, after-taxes. While it is not an additional cost you'd be paying to a bank, but paying yourself, it is money you may essentially be paying tax on twice. That is because the money you pay yourself interest with is taxed in your paycheck currently, then later when it is distributed to you from the plan in retirement as ordinary income.

No. Generally, payments that qualify as alimony are included in the recipient's gross income and are deducted from the payor's gross income. However, not all payments between spouses qualify as alimony.

Divorce or separation agreement

Payments do not qualify as alimony unless they are made under a written divorce or separation instrument. Any payment that exceeds the amount provided in the agreement, that is made before they are required by the agreement or that is made after they are no longer required by an agreement will not be considered alimony and will not be deductible as such.

The current rules apply to payments made under a post-1984 divorce or separation agreement. Covered under these rules are divorce or separation agreements executed after December 31, 1984, instruments executed before 1985 if a decree executed after December 31, 1984 changes the terms of the pre-1985 instrument, or pre-1985 instruments which are not treated as executed after December 31, 1984 but which have been modified after that date to expressly provide that the post-1984 rules are to apply.

Under the current rules, a divorce or separation agreement is defined as a divorce or separate maintenance decree or a written instrument incident to that decree, a written separation agreement, or a decree that is not a divorce decree or a separate maintenance decree but that requires a spouse to make payments for the support or maintenance of the other spouse.

Strict requirements

To be deductible, alimony payments must meet all the strict statutory requirements. First, the payment must be in cash or an equivalent and must be received by or on behalf of a spouse under a divorce or separation agreement.

Additionally, the agreement must not designate the payment as not includable in gross income and not allowable as a deduction under Code Sec. 215, the spouses who are legally separated under a decree of divorce or separate maintenance cannot be members of the same household when the payment is made, there must be no liability to make any payment after the death of the payee spouse, and spouses must not file joint returns with each other.

Lastly, the payment must not be fixed as child support. Payments that do not meet these requirements will not be considered alimony and cannot be deducted.

Different rules apply to payments made under pre-1985 divorce or separation agreements. However, a pre-1985 agreement can be expressly modified to provide that the rules for post-1984 agreements will apply to subsequent payments.

The AMT is difficult to apply and the exact computation is very complex. If you owed AMT last year and no unusual deduction or windfall had come your way that year, you're sufficiently at risk this year to apply a detailed set of computations to any AMT assessment. Ballpark estimates just won't work.

If you did not owe AMT last year, you still may be at risk. The IRS estimates that half million more individuals will be subject to the AMT in 2006 because of rising deductions and exemptions. If Congress doesn't extend the same AMT exclusion amount given in 2005, an estimated 3 million more taxpayers will pay AMT.

For a system that was intended originally to target only the very rich, the AMT now hits many middle to upper-middle class taxpayers as well. Obviously something has to be done, and will be, eventually, through proposed tax reform measures. In the meantime, expect AMT to be around for at least another year.

Basic calculations. Whether you will be liable for the AMT depends on your combination of income, adjustments and preferences. After all the computations, if your AMT liability exceeds your income tax liability, you will be liable for the AMT. Here are the basic steps to take to determine in evaluating whether you will owe the AMT:

• Step #1: Calculate your regular taxable income. If your regular tax were to be determined by reference to an amount other than taxable income, that amount would need to be determined and used in the next steps.
  
• Step #2: Calculate your alternative minimum taxable income (AMTI) by increasing or reducing your regular taxable income (or other relevant amount) by applying the AMT adjustments or preferences. These include business depreciation adjustments and preferences, loss, timing and personal itemized deductions adjustments, and tax-exempt or excluded income preferences. This is the step with potentially many sub-computations in determining increases and reductions in tax liability.
  
• Step #3:  If your AMTI exceeds the applicable AMT exemption amount, pay AMT on the excess.

While no single factor will automatically trigger the AMT, the cumulative result of several targeted tax benefits considered in Step #2, above, can be fatal. Common items that can cause an "ordinary" taxpayer to be subject to AMT are:

• All personal exemptions (especially of concern to large families);
• Itemized deductions for state and local income taxes and real estate taxes;
• Itemized deductions on home equity loan interest (except on loans used for improvements);
• Miscellaneous Itemized Deductions;
• Accelerated depreciation;
• Income from incentive stock options; and
• Changes in some passive activity loss deductions.

When trying to maximize retirement savings contributions, you may find you have contributed too much to your IRA.  Typically, you either have too much income to qualify for a certain IRA or you can't recall what contributions you made until they are added up at tax time and you discover they were too much. There are steps you can take to correct an excess contribution.

What is an excess contribution?

An excess contribution is the amount by which your total contributions to one or more IRAs exceed the applicable dollar limit for the tax year. For tax years 2005 through 2007, the maximum annual combined contribution to a taxpayer's traditional IRAs and Roth IRA is $4,000. For those 50 years or older, an additional $500 is allowed in 2005, and $1,000 for 2006 and subsequent years.  

Your total contributions also include any rollover contributions completed more than 60 days after a distribution is received from a qualified plan or an IRA. If you contribute more than the allowable amount to all IRAs, the excess is subject to a six percent excise tax.

The six percent tax is nondeductible. The tax applies in each subsequent year if excess is not withdrawn or eliminated by treating it as allowable contribution in a future year. The excise tax is also imposed on excess contributions to a Roth IRA. This tax is reported on Form 5329, Additional Taxes Attributable to IRAs, Other Qualified Retirement Plans, Annuities, Modified Endowment Contracts, and medical savings accounts (MSAs).

Steps to take

The IRS treats an amount distributed from an IRA to the individual making the contribution, before the due date (including extensions) of the individual's tax return, as not contributed to the IRA.  If your excess contribution was made by mistake, you can avoid the excise tax on excess contributions (and premature withdrawals) by withdrawing the contribution and any earnings on the contribution, on or before the due date, including extensions, of your return. 

Keep in mind that IRA contributions can only be made up to the due date of the return excluding extensions. The "corrective distribution" can be made up to the due date of the return including extensions.

If you withdraw the contribution in a timely manner, you don't have to include the contribution in your gross income if no deduction is allowed and the interest attributable to the contribution is returned. The interest, however, must be included in your income for the year the contribution was made.

It's very important that you make certain that contributions to your IRA do not exceed the allowable limits. Otherwise, you could be paying the six percent excise tax.  Fortunately, there are remedies. If you discover that you have over-contributed to your IRA, please contact our office immediately. We can help you correct your excess contribution.

Q. My company recently downsized its workforce and eliminated my position. I thought this would be a good opportunity to start my own consulting business in the same industry. What are some of the things I should consider before my last day on the job?

Q. My company recently downsized its workforce and eliminated my position. I thought this would be a good opportunity to start my own consulting business in the same industry. What are some of the things I should consider before my last day on the job?

A. Corporate downsizing and restructuring has swelled the ranks of the self-employed in recent years as those employees with an entrepreneurial spirit venture out on their own. Planning ahead for your career change while you are still on the job is a wise move and one that will most likely improve your chances for success.

Know your rights as a former employee. If you plan on bringing any of your current customers/clients with you, make sure you are familiar with the terms of any existing noncompete agreement with your employer. Violating such an agreement can put you out of business before you even get started. Consult an attorney if you are unclear on any of the details. Also confirm what your rights are to unemployment benefits and whether earnings from your new business will reduce or eliminate those rights.

Save for a rainy day. It may take a while to adjust to living without a paycheck while building your new business so make sure you have a decent cash reserve set aside before you leave your job. Many small businesses can take a year or more to become profitable so it pays to be prepared. Restrict expenditures to only items that are absolutely necessary. Consider using credit cards and/or lines-of-credit to buy furniture, inventory and other essentials for your business to conserve cash. The use of credit should, of course, be monitored closely to ensure that you don't get in over your head. Note: arrange for adequate credit before you quit, as the same credit may be difficult to get once you lose your employee status and become self-employed.

Keep your health insurance. Finding the right health insurance as a self-employed individual can take time. If your spouse has insurance through his/her employer, you may be able to be added to that policy. However, if you would like to continue with your current insurance, consider making a COBRA election with your employer to get coverage for up to 18 months following the end of your employment with the company. Contact the benefits department of your company for more information about terms and pricing.

Note. The American Recovery and Reinvestment Tax Act of 2009 alters COBRA coverage for individuals who are involuntarily separated from their employment between September 1, 2008 and January 1, 2010. Eligible individuals may elect to pay 35 percent of his or her COBRA coverage, with the former employer required to pay the remaining 65 percent under a reimbursement arrangement with the federal government.

The decision to go out on your own can be exciting and unsettling at the same time, but if you prepare well before you leave your job, your chances of a smooth transition should greatly increase. Please let us know if you need any assistance or support in this area.

Q. My family and I have always led a full life, enjoying vacations, dinners out, and new cars. While many of these items have been paid for by credit cards, we've never felt uncomfortable with our level of indebtedness. However, things have been slowing down at work lately, and I suddenly realized that I would be in big trouble if I lost my job. We are just paying the minimum on our credit cards and I'm starting to feel like we're in way over our heads. What should our next step be?

Q. My family and I have always led a full life, enjoying vacations, dinners out, and new cars. While many of these items have been paid for by credit cards, we've never felt uncomfortable with our level of indebtedness. However, things have been slowing down at work lately, and I suddenly realized that I would be in big trouble if I lost my job. We are just paying the minimum on our credit cards and I'm starting to feel like we're in way over our heads. What should our next step be?

A. You are definitely not alone. Even with the economy pumping at full-speed, American consumers are borrowing at a record pace and installment debt (more than $1 trillion of it) has never been higher. But no matter how much you owe, a sound debt-reduction plan can help you reduce your debt burden and get you on the road to financial recovery. Here are a few tips that can get you started towards good financial health:

Cut up your credit cards. This may be your first and most important step on the road to financial recovery. You may want to keep a couple of cards for emergencies but, to keep yourself from incurring more debt, consider using a "debit" card tied to your checking account.

Target high-rate debt first. Paying down the highest-rate debt first will make the most of your debt-reduction plan. Get out a piece of paper and list all of your debt, beginning with the debt with the highest rate on the top. Focus on applying as much money as possible to those debts, starting at the top of the list and working your way down.

Consider refinancing. The general rule of thumb for deciding whether or not to refinance concludes that if you'll recover the refinancing costs (usually 3-5% of the loan amount) within 3 or 4 years and you plan to stay in your home for at least one year after that, it may be worth it to refinance. And with no-fee loans, refinancing makes sense as long as the new interest rate (usually higher than the best available rate) is lower than the one on your existing loan. Of course, your ability to refinance these days depends more then ever n your "credit score," so be sure to know your score and ways to build it up if necessary.

Consolidate your debt. Combining several high-interest loans into one with a lower rate can save you thousands of dollars each year. For homeowners, home equity loans may be your best bet as the interest paid is generally tax-deductible. Also, there's help out there for those old student loans: some governmental and private lenders have low-rate consolidation options available. Many lenders these days will even lower the amount of principal that you owe on a loan if you agree to certain schedules, like credit withdrawal from your checking account. This renegotiation, however, may result in taxable income.

Ask your lenders to lower your rate. If you have a high-rate credit card, call the lender and ask for the same rate offered by their lower-rate competitor. If the lender refuses to lower your rate, go ahead and take advantage of their competitor's balance transfer special. And don't forget your mortgage lender: the last thing they want to do is write off a large home loan. In hardship cases (e.g. job loss, disability), many mortgage lenders will suspend interest charges if you convince them that doing so will allow you to resume your regular payment schedule sooner.

Don't be afraid to ask for help. If you don't feel that you can devise an effective debt-reduction plan on your own, consider calling a professional. CPAs and professional financial planners are in a position to consider your total financial situation but also consider nonprofit companies such as Consumer Credit Counseling Service (800-388-2227) that provide a low cost (but effective) alternative. Their experienced counselors will help you prepare a budget you can live with and also help negotiate with your lenders.

Getting out of debt is never as easy as getting into debt. As you prepare your debt-reduction plan, please feel free to contact the office for assistance.

You're 57 years old and as part of an early retirement package, you've just been offered a large cash bonus and salary continuation, along with a lump sum payment from the company retirement plan and continuing medical benefits. Is this a dream come true or a potential financial nightmare?

You're 57 years old and as part of an early retirement package, you've just been offered a large cash bonus and salary continuation, along with a lump sum payment from the company retirement plan and continuing medical benefits. Is this a dream come true or a potential financial nightmare?

Corporate downsizing is a fact of life for America's workforce. As companies look to reduce their payroll, many older employees are offered early retirement packages. When faced with the possibility of early retirement, many factors must be considered in order to make an informed decision.

If your retirement package is offered to you 10 years before you had planned to retire, you may have to find another job or start your own business in order to make ends meet. In general, you will need between 70 and 80 percent of your pre-retirement salary to maintain your present standard of living once you retire. This can be achieved through a combination of your company pension, Social Security benefits and any other sources of continuing income that you may have. If your health is good and you would like to continue to work elsewhere, maintaining your current lifestyle after early retirement may be possible. You would need to have other sufficient financial resources to draw upon.

In many cases, accepting an early retirement package can mean sacrificing some pension benefits. This is because these benefits are usually based on a formula that considers how many years on the job you have and your salary in the last few years of employment. To make your early retirement package more appealing, some employers add years to your age or time on the job when making the calculation. It's important to get educated on how your employer deals with this potentially costly issue.

What is the reason behind the company offering you an early retirement package? Is it possible that you may get a larger payoff or more benefits if you were to wait six months or a year? Or do you risk losing your job as part of a larger layoff? Is your company hiring or downsizing? Evaluate the company's motivation for offering you an early retirement plan as part of your decision process to avoid regrets later.

For some people, going to the office every day gives them a sense of purpose and structure in their life. Once you retire, your familiar daily routine is gone and you must find ways to fill your days. Some people flourish with the extra time now available to pursue their other interests and hobbies such as travel, exercise, or charitable work. For others, though, the loss of routine and structure in their lives can be devastating. If you do not plan to continue working, make sure that you are prepared to change your daily routine when considering early retirement.

Before you decide whether or not to accept an early retirement package, please feel free to contact our office. We would be happy to assist you as you explore your options.

Limited liability companies (LLCs) remain one of the most popular choice of business forms in the U.S. today. This form of business entity is a hybrid that features the best characteristics of other forms of business entities, making it a good choice for both new and existing businesses and their owners.

Limited liability companies (LLCs) remain one of the most popular choice of business forms in the U.S. today. This form of business entity is a hybrid that features the best characteristics of other forms of business entities, making it a good choice for both new and existing businesses and their owners.

An LLC is a legal entity existing separately from its owners that has certain characteristics of both a corporation (limited liability) and a partnership (pass-through taxation). An LLC is created when articles of organization (or the equivalent under each state rules) are filed with the proper state authority, and all fees are paid. An operating agreement detailing the terms agreed to by the members usually accompanies the articles of organization.

Choosing the LLC as a Business Entity

Choosing the form of business entity for a new company is one of the first decisions that a new business owner will have to make. Here's how LLCs compare to other forms of entities:

C Corporation: Both C corporations and LLCs share the favorable limited liability feature and lack of restrictions on number of shareholders. Unlike LLCs, C corporations are subject to double taxation for federal tax purposes - once at the corporate level and the again at the shareholder level. C corporations do not have the ability to make special allocations amongst the shareholders like LLCs.

S Corporation: Both S corporations and LLCs permit pass-through taxation. However, unlike an S corporation, an LLC is not limited to the number or kind of members it can have, potentially giving it greater access to capital. LLCs are also not restricted to a single class of stock, resulting in greater flexibility in the allocation of gains, losses, deductions and credits. And for estate planning purposes, LLCs are a much more flexible tool than S corporations

Partnership: Partnerships, like LLCs, are "pass-through" entities that avoid double taxation. The greatest difference between a partnership and an LLC is that members of LLCs can participate in management without being subject to personal liability, unlike general partners in a partnership.

Sole Proprietorship: Companies that operate as sole proprietors report their income and expenses on Schedule C of Form 1040. Unlike LLCs, sole proprietors' personal liability is unlimited and ownership is limited to one owner. And while generally all of the earnings of a sole proprietorship are subject to self-employment taxes, some LLC members may avoid self-employment taxes under certain circumstances

Tax Consequences of Conversion to an LLC

In most cases, changing your company's form of business to an LLC will be a tax-free transaction. However, there are a few cases where careful consideration of the tax consequences should be analyzed prior to conversion. Here are some general guidelines regarding the tax effects of converting an existing entity to an LLC:

C Corporation to an LLC: Unfortunately, this transaction most likely will be considered a liquidation of the corporation and the formation of a new LLC for federal tax purposes. This type of conversion can result in major tax consequences for the corporation as well as the shareholders and should be considered very carefully.

S Corporation to an LLC: If the corporation was never a C corporation, or wasn't a C corporation within the last 10 years, in most cases, this conversion should be tax-free at the corporate level. However, the tax consequences of such a conversion may be different for the S corporation's shareholders. Since the S corporation is a flow-through entity, and has only one level of tax at the shareholder level, any gain incurred at the corporate level passes through to the shareholders. If, at the time of conversion, the fair market value of the S corporation's assets exceeds their tax basis, the corporation's shareholders may be liable for individual income taxes. Thus, any gain incurred at the corporate level from the appreciation of assets passes through to the S corporation's shareholders when the S corporation transfers assets to the LLC.

Partnership to LLC: This conversion should be tax-free and the new LLC would be treated as a continuation of the partnership.

Sole proprietorship to an LLC: This conversion is another example of a tax-free conversion to an LLC.

While considering the potential tax consequences of conversion is important, keep in mind how your change in entity will also affect the non-tax elements of your business operations. How will a conversion to an LLC effect existing agreements with suppliers, creditors, and financial institutions?

Taxation of LLCs and "Check-the-Box" Regulations

Before federal "check-the-box" regulations were enacted at the end of 1996, it wasn't easy for LLCs to be classified as a partnership for tax purposes. However, the "check-the-box" regulations eliminated many of the difficulties of obtaining partnership tax treatment for an LLC. Under the check-the-box rules, most LLCs with two or more members would receive partnership status, thus avoiding taxation at the entity level as an "association taxed as a corporation."

If an LLC has more than 2 members, it will automatically be classified as a partnership for federal tax purposes. If the LLC has only one member, it will automatically be classified as a sole proprietor and would report all income and expenses on Form 1040, Schedule C. LLCs wishing to change the automatic classification must file Form 8832, Entity Classification Election.

Keep in mind that state tax laws related to LLCs may differ from federal tax laws and should be addressed when considering the LLC as the form of business entity for your business.

Since the information provided is general in nature and may not apply to your specific circumstances, please contact the office for more information or further clarification.

Do you know where your 401(k) plan funds are? Errors can and do occur, sometimes with devastating results. By taking an active role in the management of your account, you can quickly uncover any errors, make good investment choices, and ascertain a secure, comfortable retirement. Here are some guidelines to help you get the most out of your 401(k) plan.

Do you know where your 401(k) plan funds are? Errors can and do occur, sometimes with devastating results. By taking an active role in the management of your account, you can quickly uncover any errors, make good investment choices, and ascertain a more secure retirement. Here are some guidelines to help you get the most out of your 401(k) plan, which - in light of current economic times - is more important now then ever.

Watch out for errors. Your company is required to provide an annual statement that shows the amounts that were contributed to your plan throughout the year. Compare amounts withheld from your paychecks to the employee contributions recorded on your 401(k) statement. If your employer has a matching program, verify that employer contributions are being correctly allocated to your account. Make sure the plan's vesting schedule is being correctly applied to you.

Do your homework. In addition to offering the company stock, most companies also offer a wide range of investment options. By gathering information for the different investment choices offered, you have a better opportunity to make an intelligent, informed decision. If your company does not provide a fund prospectus or performance history for the mutual fund or stock choices offered, you can contact the fund or company directly to obtain this pertinent information.

Make smart investment choices. Many employees make the mistake of investing too conservatively. Since a 401(k) plan is usually comprised of a variety of diversified securities, including stock, you can take advantage of the fact that over the long term, stocks generally outperform all other investments. Diversification has its place in any portfolio, so bonds and T-bills should also be considered.

Keep an eye on your plan's performance. While the annual statement provided by your employer will give you detail as to how your investments have performed over the past year, it's a good idea to monitor your fund's investments more frequently. While a good overall return for the year may make you think that your investment mix is right on target, very strong earnings in the first part of the year may hide the fact that some of your investments have taken a turn for the worse. To monitor the individual funds and stocks that comprise your 401(k) plan, check the business section of your newspaper on a regular basis, and just go online if you're invested with one of the major funds. Remember, too, that you pay no tax on your 401(k) investments until you retire and start to withdraw from it. As a result, funds geared to the situation in which short and long-term selling are treated the same for tax purposes ought to play into your investment strategy.

Maintaining good financial records is an important, but often neglected, part of running a successful business. Not only will good records help you identify strengths and weaknesses in your business' operations, but they will also help out tremendously if the IRS comes knocking on your door.

Maintaining good financial records is an important part of running a successful business. Not only will good records help you identify strengths and weaknesses in your business' operations, but they will also help out tremendously if the IRS comes knocking on your door.

The IRS requires that business owners keep adequate books and records and that they be available when needed for the administration of any provision of the Internal Revenue Code (i.e., an audit). Here are some basic guidelines:

Copies of tax returns. You must keep records that support each item of income or deduction on a business return until the statute of limitations for that return expires. In general, the statute of limitations is three years after the date on which the return was filed. Because the IRS may go back as far as six years to audit a tax return when a substantial understatement of income is suspected, it may be prudent to keep records for at least six years. In cases of suspected tax fraud or if a return is never filed, the statute of limitations never expires.

Employment taxes. Chances are that if you have employees, you've accumulated a great deal of paperwork over the years. The IRS isn't looking to give you a break either: you are required to keep all employment tax records for at least 4 years after the date the tax becomes due or is paid, whichever is later. These records include payroll tax returns and employee time documentation.

Business assets. Records relating to business assets should be kept until the statute of limitations expires for the year in which you dispose of the asset in a taxable disposition. Original acquisition documentation, (e.g. receipts, escrow statements) should be kept to compute any depreciation, amortization, or depletion deduction, and to later determine your cost basis for computing gain or loss when you sell or otherwise dispose of the asset. If your business has leased property that qualifies as a capital lease, you should retain the underlying lease agreement in case the IRS ever questions the nature of the lease.

For property received in a nontaxable exchange, additional documentation must be kept. With this type of transaction, your cost basis in the new property is the same as the cost basis of the property you disposed of, increased by money you paid. You must keep the records on the old property, as well as on the new property, until the statute of limitations expires for the year in which you dispose of the new property in a taxable disposition.

Inventories. If your business maintains inventory, your recordkeeping requirements are even more arduous. The use of special inventory valuation methods (e.g. LIFO and UNICAP) may prolong the record retention period. For example, if you use the last-in, first-out (LIFO) method of accounting for inventory, you will need to maintain the records necessary to substantiate all costs since the first year you used LIFO.

Specific Computerized Systems Requirements

If your company has modified, or is considering modifying its computer, recordkeeping and/or imaging systems, it is essential that you take the IRS's recently updated recordkeeping requirements into consideration.

If you use a computerized system, you must be able to produce sufficient legible records to support and verify amount shown on your business tax return and determine your correct tax liability. To meet this qualification, the machine-sensible records must reconcile with your books and business tax return. These records must provide enough detail to identify the underlying source documents. You must also keep all machine-sensible records and a complete description of the computerized portion of your recordkeeping system.

Some additional advice: when your records are no longer needed for tax purposes, think twice before discarding them; they may still be needed for other nontax purposes. Besides the wealth of information good records provide for business planning purposes, insurance companies and/or creditors may have different record retention requirements than the IRS.

With home values across the country at the highest levels seen in years, you may find that you could actually have a gain from the sale of your home in excess of the new IRS exclusion amount of $500,000 ($250,000 for single and married filing separately taxpayers). In order to determine your potential gain or loss from the sale, you will first need to know the basis of your personal residence.

With home values across the country dropping significantly from just a year ago, but still generally much higher then they had been even five years ago, you may find that you could actually have a gain from the sale of your home in excess of the new IRS exclusion amount of $500,000 ($250,000 for single and married filing separately taxpayers). In order to determine your potential gain or loss from the sale, you will first need to know the basis of your personal residence.

Note. The Housing and Economic Recovery Act of 2008 modified the home sale exclusion applicable to home sales after December 31, 2008. Under the new rule, gain from the sale of a principal residence that is attributable to periods that the home was not used as a principal residence (i.e. "non-qualifying use") will be no longer be excluded from income. A transition rule provided in the new law applies the new income inclusion rule to nonqualified use periods that begin on or after January 1, 2009. This is a generous transition rule in light of the new requirement.

The basis of your personal residence is generally made up of three basic components: original cost, improvements, and certain other basis adjustments.

How your home was acquired will need to be considered when determining its original cost basis.

Purchase or Construction. If you bought your home, your original cost basis will generally include the purchase price of the property and most settlement or closing costs you paid. If you or someone else constructed your home, your basis in the home would be your basis in the land plus the amount you paid to have the home built, including any settlement and closing costs incurred to acquire the land or secure a loan.

Examples of some of the settlement fees and closing costs that will increase the original cost basis of your home are:

• Attorney's fees,
• Abstract fees,
• Charges for installing utility service,
• Transfer and stamp taxes,
• Title search fees,
• Surveys,
• Owner's title insurance, and
• Unreimbursed amounts the seller owes but you pay, such as back taxes or interest; recording or mortgage fees; charges for improvements or repairs, or selling commissions.

Gift. If you acquired your home as a gift, your basis will be the same as it would be in the hands of the donor at the time it was given to you. However, the basis for loss is the lesser of the donor's adjusted basis or the fair market value on the date you received the gift.

Inheritance. If you inherited your home, your basis is the fair market value on the date of the deceased's death or on the "alternate valuation" date, as indicated on the federal estate tax return filed for the deceased.

Divorce. If your home was transferred to you from your ex-spouse incident to your divorce, your basis is the same as the ex-spouse's adjusted basis just before the transfer took place.

If you've been in your home any length of time, you most likely have made some home improvements. These improvements will generally increase your home's basis and therefore decrease any potential gain on the sale of your residence. Before you increase your basis for any home improvements, though, you will need to determine which expenditures can actually be considered improvements versus repairs.

An improvement materially adds to the value of your home, considerably prolongs its useful life, or adapts it to new uses. The cost of any improvements can not be deducted and must be added to the basis of your home. Examples of improvements include putting room additions, putting up a fence, putting in new plumbing or wiring, installing a new roof, and resurfacing your patio.

Repairs, on the other hand, are expenses that are incurred to keep the property in a generally efficient operating condition and do not add value or extend the life of the property. For a personal residence, these costs cannot be do not add to the basis of the home. Examples of repairs are painting, mending drywall, and fixing a minor plumbing problem.

Additional items that will increase your basis include expenditures for restoring damaged property and assessing local improvements. Some common decreases to your home's basis are:

• Insurance reimbursements for casualty losses.
• Deductible casualty losses that aren't covered by insurance.
• Payments received for easement or right-of-way granted.
• Deferred gain(s) on previous home sales.
• Depreciation claimed after May 6, 1997 if you used your home for business or rental purposes.

In order to document your home's basis, it is wise to keep the records that substantiate the basis of your residence such as settlement statements, receipts, canceled checks, and other records for all improvements you made. Good records can make your life a lot easier if the IRS ever questions your gain calculation. You should keep these records for as long as you own the home. Once you sell the home, keep the records until the statute of limitations expires (generally three years after the date on which the return was filed reporting the sale)

What do amounts paid for new swimming pools, Lamaze classes, lunches with friends, massages, and America Online fees have in common? All of these costs have been found to be legitimate tax deductions under certain circumstances. As you gather your information for the preparation of your tax return, it may pay to take a closer look at the items you spent money on during the year.

What do amounts paid for new swimming pools, Lamaze classes, lunches with friends, massages, and America Online fees have in common? All of these costs have been found to be legitimate tax deductions under certain circumstances. As you gather your information for the preparation of your tax return, it may pay to take a closer look at the items you spent money on during the year.

Medical Expenses

Medical expenses that you pay during the tax year for yourself, your spouse, and your dependents are deductible to the extent the total exceeds 7.5% of your adjusted gross income. This limitation can be hard to reach if you claim only medical insurance premiums and the co-pay on your kid's doctors' visits. Keep these potential deductions in mind as you tally up this year's medical expenses:

• For your home: capital expenditures for home improvements and additions (such as swimming pools, saunas, Jacuzzis, elevators) that are added primarily for medical care qualify for the medical expense deduction to the extent that the cost exceeds any increase in the value of your property due to the improvement.

• For your children: orthodontia; remedial reading and language training classes; lead paint removal.

• For you and your spouse: Lamaze or other childbirth preparation classes (mother only); contacts and eyeglasses; prescription contraceptives & permanent sterilization; health club dues (if prescribed by a physician for medical purposes); massages (if prescribed by a physician); mileage for trips to medical appointments.

• For your aging parents: If your or your spouse has a parent that qualifies as a dependent, you can deduct: hearing aids; domestic aid (provided by a nurse); prepaid lifetime medical care paid to a retirement home; special mattresses (prescribed by a physician); certain nursing home costs.

To maximize your deduction, try to bunch your medical expenses into one year to exceed the 7.5% limit. For example, schedule costly elective medical and dental treatments to be performed and billed in the same tax year.

Taxes Paid

Many of the taxes that you pay such as real estate taxes for your home, state and local taxes, and auto registration fees are deductible as itemized deductions on your return. Don't forget these:

• Property taxes paid on boats, motor homes, trailers, and other personal property.

• Real estate taxes paid on investment property and vacation homes.
• Real estate taxes paid through escrow in association with the purchase or sale of your residence or investment property.
• Employee contributions to a state disability fund.
• Foreign income taxes paid not taken as a credit.

Interest Expense

Although in recent years Congress has made the tax laws regarding interest deductions more strict, much of the interest that you pay during the year is still deductible. For interest paid to be deductible, you must be legally responsible for the underlying debt and the debt must result from a valid debtor-creditor relationship. While gathering your home mortgage interest numbers, dig a little deeper to get this inf

• Interest paid on margin loans.
• Prepayment penalties and late fees related to your mortgage.
• "Points" (prepaid interest) on home purchases and refinances.
• Seller-paid points on the purchase of a home.

Since personal interest paid on credit cards and other unsecured loans is not deductible, it may be wise to make that interest deductible by paying off that debt with a home-equity loan. Interest on home-equity loans of up to $100,000 is generally deductible on your return.

Miscellaneous Expenses

Miscellaneous itemized deductions such as unreimbursed employee business expenses and tax preparation fees are deductible to the extent that the total of all of these expenses is more than 2% of your adjusted gross income. Here's a few more to add to the list:

• Education expenses: You may be able to deduct expenses that you paid in connection with getting an education. These expenses are generally deductible to the extent required by law or your employer or needed to maintain or improve your skills. Examples of deductible education expenses are tuition; books; lab fees; supplies; and dues paid to professional societies. Certain travel & transportation costs may also be deductible.

• Job-hunting costs: You can deduct certain expenses you incur while looking for a new job in your present occupation, even if you do not get a new job. Consider some of these job-hunting expenses: resumes, phone calls, travel & transportation costs, lunches with others regarding possible job referrals; office supplies; and employment and outplacement agency fees.

• Investment expenses: Investment expenses are any expenses that you incur as you manage your investments. These expenses include professional fees paid related to investment activities; subscriptions to investment-oriented publications; fees paid to your Internet service provider related to tracking your investments; and IRA custodian fees (if billed separately).

• Protective clothing used on the job.

• Appraisal fees for certain charitable contributions & casualty losses.
• Safe deposit box fees.

Take the time this year to evaluate all of your expenditures made last year; you may be pleasantly surprised by what you find.

The Internet has taken investing to a whole different level: inexpensive online trading and real-time stock market data have made many of us 'armchair investors'. As you actively manage your investments, you will no doubt incur additional expenses. Many of these expenses are deductible investment expenses.

Tax law allows taxpayers to deduct investment expenses if those expenses are ordinary and necessary for the production or collection of income, or for the management, conservation or maintenance of property held for the production of income.

What are investment expenses? Investment expenses are any expenses that you incur as you manage your investments. Some of these expenses are deductible (e.g. professional fees you paid related to investment activities; custodian fees, safe deposit rental; and subscriptions to investment-oriented publications), and some are not (e.g. costs related to tax-exempt securities; trading commissions (these increase the basis of the investment); and certain convention/seminar costs).

Who can deduct investment expenses? Investment expenses can be deducted by most individuals on their personal income tax returns. How these expenses are claimed depends on what type of investor a person is. Generally, investors fall into two categories: casual investor and professional trader.

Casual Investor

This category of investor describes most people actively managing their own investments. Investment expenses (except interest) are claimed on the taxpayer's return as miscellaneous itemized deductions. These expenses can be deductible on the return to the extent that they, when added to other "miscellaneous itemized deductions", exceed 2% of your adjusted gross income (AGI). The actual tax benefits derived from these excess miscellaneous itemized deductions may be further reduced due to AGI limitations for all itemized deductions and the alternative minimum tax (AMT).

In addition to the expenses noted above, if you use your computer extensively in the management of your investments, there are some other expenses to be aware of:

Online fees: You may deduct the portion of your monthly charges paid to your Internet Service Provider (ISP) incurred to manage your investments. If you subscribe to additional online services geared towards investors (e.g. The Wall Street Journal Interactive Edition) where you can follow your investments, these fees are also deductible investment expenses. Trading fees paid to online brokerages (e.g. E*Trade) are not currently deductible but are added to the basis of your investment, which will result in a reduced gain (or increased loss) upon disposition of the asset.

Software: If you purchase software that helps you manage and/or track your investments, the cost of the software may be depreciated over three years, and written off completely in the year of obsolescence. Programs that are useful for one year or less should be expensed in the year purchased, rather than depreciated.

Depreciation: Since the casual investor's investment-related use of a personal computer (and related equipment) is probably less than 50%, the cost of this equipment must be depreciated over five years using the straight-line method. The Section 179 expense deduction is not available for this type of investor.

A word of caution for self-employed individuals: if you use your home office for both business and investment purposes, you run the risk of losing your home office deduction for business purposes. A home office deduction is not available for the investment-related expenses for the casual investor. To claim a deduction for a home office for business purposes, your home office must be used exclusively for business; if you are performing investment activities in the same office space, you've just violated the "exclusive use" test.

Professional Trader

A professional trader is defined by the courts someone in between a dealer and an investor. A professional trader is a person that conducts trading activity focusing on short-term investments in large volumes on a regular and consistent basis, receives no compensation for his services, and does not have any customers. Participating in an investment club or partnership does not qualify a person as a professional trader.

If you meet the tough definition of a professional trader, you will be treated as a self-employed individual and all your investment expenses may be claimed on Schedule C of your return. You can also deduct all of your home office expenses, and you can claim Section 179 expenses for computers and other equipment used more than 50% in your business as a professional trader.

Owning property (real or tangible) and leasing it to your business can give you very favorable tax results, not to mention good long-term benefits. There are some drawbacks, however, and you should consider all factors before structuring such an arrangement.

BENEFITS

• Since you own the property personally, it is protected from the creditors of the Company should it be sued or run into financial difficulty.

• Real estate leasing outside of the corporation will offer better tax and financial advantages compared to the rental of personal property such as equipment. These advantages can include the avoidance of corporate double tax on the appreciation of the real estate, along with estate planning advantages from the step up in basis if the property is owned by the individual or partnership.
• Allows the individual taxpayer to remove earnings from the company without payment of employment taxes or increasing the possibility of unreasonable compensation issues.

DRAWBACKS

• If you are a non-corporate lessor and leasing personal property (machinery, equipment, etc.), you will have to comply with special rules in order to claim the Sec. 179 expense deduction.
• You need to charge a fair rental for your real estate or equipment. Inflated rental rates may be recharacterized as dividends if coming from a corporation.
• Leasing property to your own C Corporation cannot generate passive income. Income will be reclassified as "active" while losses will remain "passive", removing the ability to use this transaction to offset other "passive" losses.

Proper planning and knowledge of the various tax issues is important when considering this type of arrangement. Feel free to contact us for a better understanding of how these situations would effect you before you proceed.

Biweekly mortgage prepayment plans are popular in the mortgage lending industry. These plans tout substantial interest savings and shortened loan terms by making two smaller mortgage payments each month instead of one large payment. Is this type of program right for you? Is a formal plan necessary?

How does it work? Once the plan has been established, a person makes biweekly payments (equal to half of their usual monthly mortgage payment) to the plan operator. This means that a person would make 26 payments instead of the usual 12, effectively making one additional mortgage payment for the year. At the end of the year, the plan operator sends the extra money paid in during the year to the borrower's lender to be applied towards principal.

How much does it cost? Formal prepayment plans typically charge a one-time membership fee of between $300-400. In addition, the plan operator will charge you a service fee of between $1-4 on each payment.

Will it really save me money? Definitely. For example, if you are currently making 12 monthly payments of $665, or $7,980 a year, on your 30-year mortgage, with a formal prepayment plan, you would make 26 biweekly payments of $332.50, or pay $8,645 annually. As a result, total interest paid over the life of the loan would shrink by $34,130 and the loan term would shorten to less than 24 years. But don't forget the annual membership fees and biweekly service charges: these could cost you up to $2,000 over the term of your loan (even after taking into consideration the shortened loan term).

Are there other options? Do it yourself. You can devise your own prepayment plan. This plan does not have to be complicated: take your current monthly payment, divide it by 12 and send the extra amount in with your regular monthly payment. Or just send in one extra payment at the end of the year. You will still reap the benefits without paying any extra administrative fees or getting stuck in a plan you can't commit to for the long term. For example, with a 30-year fixed mortgage for $100,000 at a 7 percent interest rate, a borrower would have monthly principal and interest payments of about $665, and pay $139,508 in interest over the life of the loan. By adding $25 a month, the same borrower could shorten the term by just over three years and save about $18,214 in interest. Sending in even more, say an extra $200 every month, would save $72,695 in interest, and the loan would be paid off in about 16 years. And you've avoided paying the extra fees of almost $2,000.

A couple things to consider before starting any prepayment plan:

• Make sure that you follow your lender's procedures for making additional principal payments. You may need to send two checks and write "Principal Only" on one of them or indicate the additional principal payment on your payment voucher.

• Watch out for prepayment penalties. These penalties usually only apply when a borrower refinances, but some can be activated if a borrower pays more than 20 percent of the loan's principal during any one year early in the loan. The penalty can be as much as six month's interest on the amount paid that exceeds the lender's allowed prepayment.

A. When you contribute an auto to a charitable organization, you must determine its fair market value at the time of the contribution to determine the amount of the charitable deduction on your tax return. For a contribution valued at over $5,000, a written appraisal is required and must be attached to the return.

While guides like the Kelly Blue Books are helpful and can provide a good estimate of the value of your auto, the values shown are not "official" and do not qualify as an appraisal of any specific donated property. Once a qualified appraisal of the property has been secured, you must complete Section B of Form 8283 for each item or group of items for which you claim a deduction of over $5,000. The organization that received the property must complete and sign Part IV of Section B. Failure to properly report the contribution on Form 8283 or attach the appraisal report can result in the IRS disallowing your deduction for your noncash charitable contribution. Please note that appraisal fees do not increase your charitable deduction but are miscellaneous itemized deductions on Schedule A of Form 1040.

Below is a list of questions and answers to some of the basic topics you come across when reporting the sale of stock.

17. Is stock a capital asset?

1. As a general rule, any property that is owned and used by an individual for either personal or investment purposes is a capital asset. Some examples of this can be homes, furniture, cars, stocks and bonds. A sale of most capital assets will require reporting to the Internal Revenue Service (IRS) on your tax return. Losses on the sale of personal items, such as a car, furniture or personal residence, are not deductible, but may still be reportable.

17. What is a "holding period"?

1. Gains and losses on sales of stock need to be categorized as either long-term or short-term holding periods depending upon the length of time the stock is held. The date of disposition, called the trade date, is the date used for the sale. A short-term holding period would be defined as less than 1 year from date of purchase to date of sale. A long-term holding period would be one year or more.

17. What is meant by "stock basis"?

1. The cost of your stock is usually the basis. This will include commissions and recording or transfer fees. The basis of inherited stock is its fair market value (FMV) at the date of the decedent's death (unless a federal estate tax return was filed and an alternate valuation date chosen). To determine the basis of stock you receive as a gift, you must know the adjusted basis in the hands of the donor just before it was given to you, its FMV at the time it was given to you, and the amount of gift tax, if any, paid on it.

17. Do I need to save the purchase confirmations when I buy stock?

1. Yes! This helps support your documentation showing the purchase date, price and expenses. With mutual funds and stocks, it is important to keep the last statement of the year as this normally provides a summary for the year of all purchases, dividend reinvestments, etc.

17. What amount do I report as my sales price?

1. If you sold your stock through a broker, you should receive Form 1099-B, Statement for Recipients of Proceeds From Broker and Barter Exchange Transactions, by February 1 of the year following the year the transaction occurred. The amount reported to you on Form 1099-B as gross proceeds will usually consists of the total proceeds of the sale less any commissions or fees incurred on the sale. If, for some reason the amount reported as "Gross Proceeds" does not take into account any commissions or fees paid, you should add these selling expenses to the basis of the stock sold.

17. How important is Form 1099-B?

1. The amount reported on Form 1099-B is entered into the IRS computer and "matched" against the amount reported on your tax return. As a result, Form 1099-B is very important if you wish to avoid any further correspondence and/or inquiry by the IRS.

17. What is a wash sale?

1. A wash sale occurs when you sell a specific stock and, within 30 days before or after the sale, you purchase substantially identical stock. Losses from wash sales are not deductible, but are used to figure the basis of the new stock. Any gain, however, is taxable.

17. Is there a limit on the amount of capital loss I can deduct?

1. Yes. If, after combining all your capital gains and losses for the year you end up with a net capital loss, the maximum loss you may deduct would be limited to $3,000 per year ($1,500 if you are married and file a separate return). Net losses in excess of $3,000 can be carried forward to the following years until they are used up.

17. I frequently switch from one mutual fund to another. Do I have to report these transactions on my tax return?

1. Yes! If you sell or exchange shares of a mutual fund with a fluctuating share price, the IRS considers the transaction a taxable event, just like the sale of stock. You must calculate a capital gain or loss for each sale or exchange -- whether made by telephone, wire, mail or even a check. You should receive a Form 1099-B for each transaction.

   Calculating gain or loss on the sale of mutual fund shares can be quite complex. Please feel free to contact the office for additional information regarding the different methods available for determining basis in your mutual funds.