Frequently, taxpayers think that gifts of cash, securities or other assets they give to other individuals are tax-deductible and, in turn, the gift recipient sometimes thinks income tax must be paid on the gift received. Nothing is further from the truth. To fully understand the ramifications of gifting, one needs to realize that gift tax laws are interrelated with estate tax laws.

When a taxpayer dies, his or her gross estate (to the extent it exceeds the excludable amount for the year) is subject to estate taxes. The exclusion for taxpayers dying in 2006 through 2008 is $2 million. In addition, there is an unlimited spousal deduction for married couples. The amounts in excess of these exclusions are subject to inheritance taxes as high as 46%. Naturally, individuals want to do whatever they can to maximize the inheritance to their beneficiaries and limit the amount of inheritance tax on the estate. Since giving away one’s assets before they die reduces the individual’s gross estate, the government has placed limits on gifts and if those gifts exceed the limit they are subject to gift tax that must be paid by the giver.

Gift Tax Exclusions – Certain gifts are excluded from the gift tax.

Annual Exclusion – This is the annual amount that an individual can give to any number of recipients. This amount is adjusted for inflation, and for 2006, it is $12,000. For example, a taxpayer with five children can give $12,000 to each child in 2006 without any gift tax consequences. The taxpayer cannot deduct the gifts, and the gifts are not taxable to the recipients. Generally, for a gift to qualify for the annual exclusion, it must be a gift of a “present interest.” That is, the recipient’s enjoyment of the gift can't be postponed into the future. There is an exception to the present interest rule where the recipient is a minor and the terms of a trust provide that the income and property may be spent by or for the minor before the minor reaches the age of 21 with the balance going to the child at age 21. This allows parents to set assets aside for future distribution to their children while taking advantage of the
annual exclusion in the year the trust is set up.

Lifetime Limit – In addition to the annual amounts, taxpayers can use a portion of the federal estate tax exemption (it is actually in the form of a credit) to offset an additional $1 million during their lifetime without gift tax consequences. However, to the extent this credit is used against a gift tax liability, it reduces the credit available for use against the federal estate tax at the taxpayer’s death. For example, if an individual had, before dying in 2006, taken advantage of the option and had given away $1 million, the individual in effect had already used up $1 million of his or her $2 million estate tax exemption. Thus, his or her estate in excess of $1 million would be taxable.

Education & Medical Exclusion – In addition to the two dollar limitation amounts listed above, there are two additional types of gifts that can be excluded from the gift tax:

(1) Amounts paid by one individual on behalf of another individual directly to a qualifying educational organization as tuition for that other individual.

(2) Amounts paid by one individual on behalf of another individual directly to a provider of medical care as payment for that medical care. Payments for medical insurance qualify for this exclusion.

Gifts of Capital Assets – Sometimes a gift might be in the form of securities, real estate, or other items that have appreciated in value. In these situations, the gift value is the item’s fair market value at the time of the gift. However, when the recipient of the gift sells that asset, he or she will measure his or her gain from the giver’s tax basis. For example, a parent gifts 100 shares of XYZ, Inc., worth $9,000 to his or her child. If the parent originally paid $5,000 for the shares and if the child sold the shares for $9,000, the child (the recipient) would be liable for the tax on the $4,000 gain. In effect, the parent (giver) transferred the taxable gain in the stock to the child. This can be beneficial from a tax standpoint if the child is in a lower tax bracket than the parent.

Gift-Splitting by Married Taxpayers - If the gift-giver is married and both spouses are in agreement, gifts to recipients made during a year can be treated as split between the husband and wife, even if the cash or property gift was made by only one of them. Thus, by using this technique, a married couple can give $24,000 a year to each recipient under the annual limitation discussed previously.

If you have additional questions or would like this office to assist you in planning an appropriate gifting strategy, please give us a call.

Let’s assume you own a home, a second (vacation) home, and a rental property. All of these properties have significantly appreciated in value over the past few years. Now it’s time to cash in on the appreciation. With careful planning, it is possible to apply the full home sale exclusion on all three of the properties.

Here is how it works. The tax code allows you to exclude up to $250,000 ($500,000 for married couples) of gain from the sale of your primary residence if you have lived in it and owned it for two of the five years immediately preceding the sale and you have not previously taken a home sale exclusion within the two years immediately preceding the sale. In addition, there is no limit on the number of times you can use the exclusion as long as the requirements are met.

It makes sense to start off by selling the home you currently live in because you probably already meet the two-out-of-five years ownership and use tests. The next step would be to move into either the rental or the second home and make it your primary residence.

After you have lived there for two full years and it has been over two years since the previous home was sold, you can sell the property and take the home sale exclusion again. The final step would be to occupy the third residence and live there for the required amount of time. When that time is up, you can sell it and take the third exclusion. This makes it possible for a married couple to exclude as much as $1,500,000 of income in just over four years if they follow the rules carefully and time the sales correctly.

The only catch is when the rental is sold. The tax code does not allow you to use the exclusion to offset profit that is attributable to the depreciation that you claimed on rental property during the time it was rented. However, the home sale exclusion can be used to offset any other gains from the rental up to the exclusion limits.

There is one final issue to consider. If any of the residences were acquired though a tax-free exchange from another property, then the residence must be owned for a period of five years prior to its sale in order to qualify for the exclusion.

Since situations may differ, we highly recommend that you consult with this office prior to initiating such a plan.

The employer will grant the employee an option to buy a specific number of shares of the employer’s stock for a specific price with an option expiration date sometime in the future. It is up to the employee to decide when (before the option expires) to exercise the option. Obviously, an employee will not exercise the option until the stock is trading higher and will try to exercise it when the stock is trading well above the option price.

When the option is finally exercised, the difference between the option price and the exercise price (stock trading price) for that block of stock is added to the employee’s W-2, whether or not the employee immediately sells the stock or holds onto it.
Thus, if the employee decides to hold onto the stock, he would have to purchase the stock with his own funds and pay the taxes that the appreciation added to his W-2.

Since holding onto the stock is generally not a good option, most employees will simply cash out of the option by having the employer transfer the stock to a broker. The broker, in turn, sells the shares and then returns the cost of the shares, along with any applicable tax withholding, to the employer and issues the employee with a check for the difference. Thus, the employee never actually has to come up with funds to purchase the shares. However, this is also where some taxpayers can inadvertently get double taxed, because income is already in the W-2 and then they also report the stock gain on their tax return.

Example – Ralph, who earned $50,000 from his employer in wages, also exercised an option during the year. The option was for 500 shares, and the option price was $20 per share. When he exercised the option, the stock was trading for $40 per share. Thus, the broker sold the block of shares for $20,000 (500 x $40). Ralph’s cost was $10,000 (500 x $20), so Ralph nets $10,000 on the transaction. But, before sending Ralph his check, the broker also withholds: $1,500 for income tax, $765 of FICA and Medicare and a $150 broker’s fee. As a result, Ralph’s check is only $7,585 ($10,000 - $1,500 -$765 - $150). The broker also sends Ralph’s employer $12,265, which includes: $10,000 that Ralph paid for the shares, the $1,500 of tax withholding and the $765 FICA and Medicare taxes. Ralph’s W-2 will show wages of $60,000, and the withholding will include the withholding amounts returned to the employer by the broker. However, the broker is required to report the stock transaction to the IRS who, in turn, will be looking for it on Ralph’s tax return. Thus, Ralph must include the transaction on his reporting with the sale price as $20,000 and the cost as $20,150 (the $10,000 cost plus the $10,000 added to the W-2 plus the $150 broker’s fee), which will result in a $150 short-term loss.

As you can see from the example, it is quite easy for these transactions to create confusion and lead to errors on the tax return. As a planning tip, since non-statutory options are subject to FICA, taxpayers with income near the annual FICA maximum should carefully plan when to exercise their options so as to avoid or minimize the FICA tax on the options. Please call this office for assistance in planning the exercise of options to insure that there are no surprises at tax time.

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The IRS recently released its statistics of income publication, which included statistical data for audit rates for the fiscal year 2005 and compared them to 2004. The data shows that the audit trend rate is up. Note: This data refers to audits of all years from the fiscal year October 1, 2004 through September 30, 2005.

Of the 130.6 million returns filed, 1,215,308 returns were audited, providing an overall audit rate of 0.93%. This was just under a 21% increase over the 0.77% overall audit rate for the prior (2004) fiscal year.

The overall rate may be somewhat misleading, however, since many returns are short forms without deductions and credits. The statistical data provided more detail, allowing us to see which returns are currently the focus for audit.

Returns with Earned Income Credit (EIC) – Low-income taxpayers receive a refundable tax credit based on income and number of children. It has been identified by the IRS as one of the areas of taxes with significant fraud. Of all returns audited in 2005, 42.9% were returns that included EIC

Face-to-Face Audits – The IRS relies heavily on computer analysis to pick up on unreported income and overstated deductions. They do this by matching W-2s, 1099s, escrow closings, broker statements, and a variety of other documents reporting taxpayer income and deductions. These computer-matching type audits are not included in the audit statistics. The audits included in the statistics were only correspondence-type and face-to-face audits. By utilizing correspondence techniques, they were able to minimize the number of face-to-face audits, which for 2005 were only 20.3% of the total.

Individual Return Audit Selection by Income – The IRS is generally selective and audits those returns with the greatest potential for providing the most additional tax revenue.

Generally, audit rates have been on the increase over the last few years and are anticipated to continue increasing in the foreseeable future.

However, just because the dues are not deductible, it does not mean you cannot deduct 50% of the cost of otherwise allowable business entertainment at a club. For example, if you have dinner with a client at your country club after a substantial and bona fide business discussion, 50% of the cost of the dinner would be a deductible business expense.

The club dues disallowance rule generally does not apply to dues paid to professional organizations, including trade, bar, and medical associations. It also does not apply to civic or public service type organizations, such as the Lions, Kiwanis, or Rotary clubs. The dues paid to local business leagues, chambers of commerce, and boards of trade are not affected by the rule either. However, an organization isn't exempt from the disallowance rule if its principal purpose is to provide entertainment facilities for its members, or to conduct entertainment activities for them.

CAUTION: Even if an organization is exempt from the club dues disallowance rule, the dues that are paid are not automatically deductible. No deduction is allowed unless you can show that the amount paid is an ordinary and necessary business expense. If you have questions regarding club dues, please give our office a call.

Over the past few years with mortgage interest rates at or close to all-time lows, it was relatively easy to replace a variable loan with another loan or a low-interest fixed rate loan whenever the variable began to adjust and lose its attractiveness. With home mortgage rates rising very slowly and real estate appreciating at double digit rates, few borrowers are concerning themselves with a potential trap that will be created if there is a downturn in home appreciation, coupled with rising interest rates.

History tends to repeat itself, and if you remember a few years back (1986 through 1994, to be exact), we had a downturn in real estate prices. You may also remember when mortgage interest rates were in the double digits. Could this happen again? No one knows for sure, but you need to be concerned how such a scenario might affect you. Should you refinance into a fixed rate mortgage now while the interest rates are still relatively low and real estate prices are still stable? Are you financially secure enough to absorb increased mortgage payments from your variable loan? Or is this a risk you shouldn’t take?

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All of the notoriety from the Schiavo case points out the need for everyone to have an effective living will (also sometimes referred to as an advance medical directive). The purpose of the document is to give someone else the power to make your medical decisions when you are no longer able to make them yourself.

Many times these are life and death decisions that must be made by a loved one. The issue of course is that your wishes, under various circumstances, can and will be carried out per your orders. Hopefully, this can be accomplished without creating dissention among family members. That is why it is important to discuss these issues with your family members prior to drafting the document so that your attorney can address any potential conflicts that may arise. Lastly, you don’t want to put the individual named as the decision maker in a position of guilt when end-of-life decisions must be made. That person needs to know that they are doing what you would have done yourself and not left to doubt the decision later.

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A recent Congressional Research Service Report says that despite restrictive provisions in the 2004 Jobs Act limiting the first-year Sec 179 expensing deduction to $25,000 (was over $100,000), the tax law still encourages business taxpayers to purchase heavy sport utility vehicles (SUVs) for business use.

The report also notes that several pieces of legislation currently in Congress will act to curtail the tax benefits of acquiring heavy SUVs, by either subjecting them to the same luxury auto rules that apply to passenger vehicles or by imposing fuel-efficient incentives for SUVs. The rapidly rising gasoline prices may in themselves make heavy SUVs unattractive regardless of the tax benefits.