August, 2006

A House Divided

Looking for a really great gift for a child or grandchild? What about a house? Of course, that's an exaggeration. But the idea isn't as far-fetched as you may think. You may be able to help your favorite young adult buy a home through an equity-sharing arrangement - and give yourself some extra tax breaks at the same time.

Utilities Not Included With an equity-sharing arrangement, you provide money for a down payment (or a portion of the down payment) and contribute toward the mortgage payments every month. Your child then pays you to rent your portion of the home.

The amount of rent should be based on your percentage of ownership and fair market rental rates. You and your child would split the property taxes, homeowners insurance premiums, and maintenance expenses proportionately.

Tax Results For tax purposes, the rent you receive is passive income - and it's taxable in the year you receive it. However, your out-of-pocket rental expenses are tax deductible. You can also claim depreciation deductions for your portion of the home.

If your expenses are greater than your rental income, your deduction for the loss will be limited by the tax law's "passive activity" rules. Under those rules, losses are deductible only up to the amount of any other passive income you might have, plus another $25,000 if your adjusted gross income is $100,000* or less and you "actively participate" in management decisions regarding the home's upkeep, etc. Any losses that aren't deductible because of these rules can be carried over and applied to passive income in future years - or deducted in full when you sell your interest in the home.

To Market, To Market When the time comes to sell, whether you sell your interest to your child, or the home is sold on the real estate market, your profit (if any) will be taxable as a capital gain. If you've owned your interest for more than a year, the profit will be taxed at the long-term capital gains rate (no more than 15% through 2010).

The tax rules are complicated. So, before setting up an equity-sharing arrangement, talk with us.

The federal alternative minimum tax (AMT)used to be relatively obscure, a tax that very few people knew about or ever had to pay. No more. AMT is hitting the pocketbooks of more individual taxpayers every year.

The AMT computation involves taking a taxpayers regular taxable income, making a series of mandated adjustments to that income, and then subtracting an AMT exemption amount. If the tax on the new bottom line (figured at the AMT rates of 26% and 28%) is more than the taxpayer's regular tax liability, then both the regular tax and the excess AMT must be paid.

Tax legislation enacted in May increased the 2006 AMT exemptions to $62,550 for married taxpayers filing jointly and $42,500 for unmarried taxpayers (both amounts subject to phase-out at higher income levels). Absent additional legislation, the exemptions will be much lower in 2007.

Deciding whether to buy or lease equipment is a choice business owners frequently face. Cost, of course, is an important consideration. You generally won't need as much money up front to lease equipment as you will to purchase it. So leasing may leave your company in a better cash position. But cost isn't the only consideration. Here are some other things to look at.

Your Time Frame How long will you need the equipment? Leasing equipment to fill a short-term need is probably the better choice, unless you know ahead of time that you'll be able to resell your purchase for a good price. For long-term use, however, purchasing equipment may be the way to go.

The Next More How soon will the equipment need to be upgraded or replaced? Some types of equipment - particularly technical and highly specialized equipment - become obsolete quickly. Leasing may give you more options. Depending on the type of lease, when it ends you may be able to choose among buying the equipment at fair market value, renewing the lease, leasing newer equipment, or walking away.

Your Expenses Owning equipment means you'll be responsible for maintenance and repair. If you decide to buy a piece of equipment, research its repair history and the available of reliable services. Leasing arrangements often include maintenance.

Your Taxes If you own equipment used in your trade or business, you are generally entitled to deductions for regular depreciation (or a first-year write-off under Code Section 179). Lease payments generally are tax deductible, unless the lease agreement is treated as a conditional sales contract instead of a "true lease."

Your Debt Load Financing an equipment purchase will add to your current debt load, which may affect your ability to get credit for other things. If you are going to need additional credit in the near future, think twice about increasing your debt.

Putting income-earning investments in a child's name has long been a popular tax-savings strategy for families. Parents can make gifts to their children and reduce their own income-tax liability in the process. This kind of income-splitting arrangement was reined in by the so-called "kiddie tax" rules, which were designed to limit the tax savings families could realize. A recent change to the kiddie tax rules limits those savings even further.

It's About Tax Rates
In 2006, the first $850 of a child's unearned income is tax free. The second $850 is taxed at the child's tax rate, which is usually substantially lower than the parents' rate. Under the kiddie tax rules, any additional unearned income is taxed at the parents' rate.

The kiddie tax rules previously applied to children under the age of 14. Beginning in 2006, the rules will apply to children under age 18, eliminating four years of potential tax savings.

Opportunities Still Exit
One way to adjust to this change may be to shift the assets in a child's portfolio away from investments that produce current income and focus on growth-oriented investments, at least until the child reaches age 18. There are also several tax-advantaged possibilities, such as traditional and Roth individual retirement accounts (if the child has earned income), Coverdell Education Savings Accounts, and Section 529 college savings program

Let us know if you'd like to discuss some tax-planning alternatives in light of this rule change.

An annuity check is dated December 28, 2006, but isn't received in the mail until January 2, 2007. In which year will the payment be taxable?

Taxable payments made by check are usually included in income in the year the check is received. But, as the IRS recently pointed out, that's not always the case. If a payment is "constructively" received in an earlier year, that's when it has to be reported for tax purposes.

This rule could cause a timing problem for taxpayers receiving monthly annuity checks through the mail. If a taxpayer has the option to receive payment by direct deposit but chooses t receive a check instead, the IRS will consider the payment constructively received n the date the direct deposit would have been made. So, the above-mentioned check would have to be reported in 2006 if direct deposit in December was available.

A retirement plan is a great employee benefit. The flipside is that most types of plans are subject to numerous government regulations. So many, in fact, that it's easy to see how an employer might fail to dot every "i" and cross every "t" in operating its plan. Since noncompliance can result in a loss of plan-related tax benefits, an employer that discovers problems with its plan should consider taking advantage of the IRS's Employee Plans Compliance Resolution System (EPCRS).

Two EPCRS programs allow employers to correct errors voluntarily, before they are potentially uncovered in an IRS audit. A third program is restricted to the correction of failures that the IRS has identified during an audit of the plan.

The Self-Correction Program allows an employer to identify a mistake that was made in the operation of its plan and correct the error without notifying the IRS or paying a fee.

The Voluntary Correction Program requires the employer to submit proposed corrections to the IRS for approval and obtain the IRS's written consent before making the corrections. There is a fee for using this program.

The Audit Closing Agreement Program is restricted to violations discovered on audit. In lieu of disqualifying the plan, the IRS requires the employer to pay a negotiated monetary sanction.

Recent changes in EPCS give employers some new opportunities to correct certain problems with their plans. For example, the revised Voluntary Correction Program allows employers to correct errors in administering plan loans. The revised program also includes a simplified and inexpensive correction method for plans that failed to timely adopt good-faith amendments required by the Economic Growth and Tax Relief Reconciliation Acts of 2001 (EGTRRA).

If you have a concern about whether your organization's retirement plan is in full compliance, EPCRS is worth a closer look. Let us know if you need more information.

The U.S. Securities and Exchange Commission has decided not to exempt small public companies from the internal control reporting requirements of the Sarbanes-Oxley Act. Small companies had sought an exemption because of the high costs of compliance.

The tax rate on long-term capital gains and qualified dividends will remain low through 2010, thanks to federal tax legislation enacted in May. The maximum rate is generally 15% (5% if the gain/dividend would otherwise be taxed at 10% or 15% if it were ordinary income). For 2008-2010, the 5% rate drops to 0% - a boon for low-bracket investors.

In audits of manufacturers and retailers, the IRS has been scrutinizing uniform capitalization (UNICAP) computations, which affect the allocation of costs to inventory In view of the IRS's increased audit activity, companies that have not reviewed their UNICAP methods recently may wish to do so.

Only 37 Fortune 100 companies continued to offer traditional pensions in 2005, down from nearly 90 companies 20 years earlier.

When the Sanchez family started their catering business, they were the only caterer in town. Now they are one of three - and business is suffering. They're thinking about converting part of their building into a restaurant to supplement their income.

Outside competition can encourage a business to diversify. A restaurant seems like a natural addition for the Sanchez family to consider as they try to rebuild their sales.

Small businesses, especially those that concentrate on one or two speciality products or services, are very vulnerable to change. A change in the local economy - two new direct competitors - took the Sanchez family by surprise. Many other factors that are beyond the control of business owners, such as the loss of a key employee or changes in the overall economy, can affect sales as well. Having more than one revenue source can help one sales channel pick up the slack and keep the cash flowing when another sales channel is lagging.

The Sanchez family is wise to diversify in a way that complements their core business. The expense of opening a restaurant should be fairly reasonable since they already own food preparation equipment. And there's a good chance that their restaurant will help bolster catering sales by introducing their products to a new audience.

Diversifying your core business can be exciting. However, as with any strategic decision, you'll want to carefully evaluate the short and long range financial impact before acting. That's where we can help.

Question: Several of your salespeople are going to be spending more time on the road and will need laptops. To free up space in the office, we want to dispose of the computers they have now. The computers are in good working condition, but we don't want to bother trying to sell them. Any ideas?
Answer: You could donate the computers to a community nonprofit or a local school. But be careful. If the hard drives contain business or personal information, you'll want to destroy the data with security software designed for that purpose before making the donation.

Question: My wife has given notice at her job. Her employer has told her that the amount she recently borrowed form her 401(k) account will be taxable to her if she doesn't repay the loan within 30 days of leaving the company. Could that be true?
Answer: Your wife's employer is probably correct, although you should check the plan's provisions to be certain. It's not uncommon for a retirement plan to treat outstanding balances on participant loans as taxable distributions upon termination of employment.