Tax & Business Strategies Monthly Newsletter - March 2007

Tax Planning Strategies
“Where's My Refund” Usage at Record Pace
Changes to Tax Laws Affecting 2006 Returns
Tuition for School to Treat Learning Disabilities is Deductible
Guidelines for Roth IRA Contributions
Penalties for Early Distributions from Retirement Plans

Business & Management Practices
Related Party Swap is Tax-Free Despite Post-Exchange Sale
Home Not Excludable From Insolvency Exclusion Computation

General Information
Missing a Form 1099?
It's Important to Pay Taxes in Full
Purchasers of GM and Ford Hybrids Still Qualify for Tax Credit
Phase-Out Credit for Toyota and Lexus Hybrids Continues
The Downside of Adding Your Child’s Name to the Deed

Briefs
Are Social Security Benefits Always Taxable?
Ways to Hold Title to Assets

TAX PLANNING STRATEGIES

“Where's My Refund” Usage at Record Pace

The IRS announced that more people than ever are using “Where's My Refund,” the popular Internet-based service used by taxpayers to check on their federal income tax refunds. More than 21 million requests have been received on “Where's My Refund” so far this year, representing a growth of more than 20 percent compared to the same period last year.

Taxpayers can securely access their personal refund information through the web site at IRS.gov. All they need to do is enter their Social Security number, filing status and the exact amount of their refund. These shared secrets, which are data known only to the taxpayer and IRS, verify the person is authorized to access the account.

The IRS reminds taxpayers to not share any of this data to anyone claiming to be the IRS in an e-mail. The phony e-mail scheme is called “phishing,” and it is an attempt to get private information such as Social Security, credit card or bank account numbers from taxpayers. The IRS reminds taxpayers it does not send out unsolicited e-mails.


Taxpayers have been successful almost 81 percent of the time when they try to access their accounts on “Where's My Refund.” The IRS says the major reason some taxpayers are not successful in accessing their accounts is because they are not entering the exact refund amount in whole dollars from the return they submitted.

Taxpayers can check on the status of their federal income tax refunds seven days after their return was e-filed. If they file a paper return, they can check four to six weeks after mailing their return.

If 28 days have passed after the IRS says it mailed a refund check, a new feature on “Where's My Refund” enables taxpayers to initiate a trace. The refund trace allows taxpayers to update a flawed mailing address. However, taxpayers who are married and file a joint return must also complete and fax or mail a copy of Form 3911, “Taxpayer Statement Regarding Refund.” Signatures of both taxpayers must be on the form. This form is required only for those whose filing status is married, filing jointly.

The IRS says taxpayers can avoid undelivered refund checks by having their refunds directly deposited into a personal checking or savings account. Direct deposit also guards against theft and lost refund checks. Direct deposit is available for both paper and electronically filed returns.

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Changes to Tax Laws Affecting 2006 Returns

Taxpayers should be aware of the new tax laws that apply to 2006 returns. The following is a list of the ones that are more frequently encountered.

• New energy-saving tax credits. A ten percent credit can now be claimed for various energy-saving improvements made to the taxpayer’s main residence. There is also a thirty percent credit for the cost of energy-saving property, such as photovoltaic cells. These credits also apply to 2007 if the taxpayer didn’t take advantage of the tax break last year.

• Expanded tax savings for retirement plans. 401(k) and 403(b) plans can now create a qualified Roth contribution program. This means that a taxpayer can choose between the normal pre-tax (deductible) contribution and the post-tax (non-deductible) Roth option that provides tax-free retirement. Check to see if your employer’s plan offers this option. If you need assistance evaluating the pros and cons of each option, please give this office a call.

• Retirement contributions from tax-free combat pay. Military members serving in Iraq, Afghanistan and other combat zone localities can now count tax-free combat pay when figuring how much to contribute to a Roth or traditional IRA. This new law is actually retroactive to 2004 for those who might want to make retroactive contributions and file amended tax returns.

• Military reservists not subject to early distribution tax. Reservists called to active duty can now receive payments from retirement plans without being subject to the ten percent early-distribution tax.

• New rules on donations to charity. To be deductible, clothing and household items donated to charity after Aug. 17, 2006, must be in good used condition or better.

• Tax-free transfers from IRAs to charity. An IRA holder, age 70 ½ or over, can directly transfer tax-free, up to $100,000 per year to an eligible charity. This option is available in tax years 2006 and 2007.

• “Kiddie” tax age change. Children under 18 with taxable investment income may need to pay at their parents’ higher marginal rates. Before, so-called “kiddie” tax applied only to children under 14.

Also this year, two changes may affect the amount of your refund or the way in which you choose to receive your refund.

• Telephone excise tax refund. Individual taxpayers will be able to request a refund if they paid the federal excise tax on long-distance or bundled service.

• New split refund option. Taxpayers now can split their refunds among up to three accounts held by up to three U.S. financial institutions, such as banks, mutual funds, brokerage firms or credit unions. If you wish to have split refunds, please remember to provide the bank routing and account number for each account.

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Tuition for School to Treat Learning Disabilities is Deductible

IRS has privately ruled (PLR 20052103) that tuition for a child diagnosed with multiple learning disabilities at a school designed to assist students in overcoming their disabilities and developing appropriate social and educational skills was a deductible medical expense.

Treating a child's learning disabilities can place a heavy financial burden on parents. As the new ruling illustrates, the tax law may help by allowing a deduction for the cost of educating such a child.

However, like other deductible medical expenses, this cost is deductible only to the extent that medical expenses for the year cumulatively exceed 7.5% of the taxpayer's adjusted gross income.

Medical care includes the cost of attending a special school designed to compensate for or overcome a physical handicap, in order to qualify the individual for future normal education or for normal living. This includes a school for the teaching of Braille or lip reading. The principal reason for attending must be the special resources for alleviating the handicap. The cost of tuition for ordinary education that is incidental to the special services provided at the school, and the cost of meals and lodging supplied by the school also is included as a medical expense. The distinguishing characteristic of a special school is the substantive content of its curriculum, which may include some ordinary education, but only if the ordinary education is incidental to the school's primary purpose of enabling students to compensate for or overcome a handicap.

IRS ruled that where the school uses special teaching techniques to assist its students in overcoming their condition, and that these techniques along with the care of other staff professionals are the principal reasons for the child's enrollment at the school, then the school is a "special school." Thus, the child's tuition at the school in those years he is diagnosed as having a medical condition that handicaps his ability to learn are deductible.

The Tax Court has also held and IRS has privately ruled that, where a school attended by a student with a medical problem doesn't qualify as a special school because the ordinary education isn't incidental to the special services provided, the costs of the special program or special treatment (but not the entire tuition) may still be a deductible medical expense.

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Guidelines for Roth IRA Contributions

Taxpayers that are confused about whether or not they can contribute to a Roth IRA should consider guidelines based on the following categories:

• Income Limits - To contribute to a Roth IRA, you must have compensation (e.g., wages, salary, tips, professional fees, bonuses). These limits vary depending on your filing and marital statuses.

• Age - There is no age limitation for Roth IRA contributions.

• Contribution Limits - In general, if your only IRA is a Roth IRA, the maximum 2006 contribution limit is the lesser of your taxable compensation or $4,000 ($5,000 if 50 or older). The maximum contribution limit phases out depending on your modified adjusted gross income (MAGI). The following table shows where the phase out begins and when the phase out is complete, based on filing status for 2006 and 2007.

Caution: Unless you are sure your income is below the phase-out levels illustrated above, you are cautioned not to make Roth IRA contributions without first consulting with this office. Making contributions that do not meet the qualifications will have to be withdrawn or converted to a traditional IRA and can be subject to penalties and lead to a lot of aggravation.

• Spousal Roth IRA - You can make contributions to a Roth IRA for your spouse provided you meet the income requirements.

• Timing - Contributions to a Roth IRA can be made at any time during the year or by the due date of your return for that year (not including extensions). The due date for filing the 2006 return is April 17, 2007. Thus, contributions for 2006 can be made through April 17th.

Roth IRA contributions are not tax-deductible and are not reported on your tax return. On the other hand, you do not include in your gross income, and therefore are not taxed on, any qualified distributions or distributions that are a return of your regular Roth IRA contributions or that are rolled over into another Roth IRA. Thus, after meeting the contribution aging requirements (generally 5 years) the income earned from the Roth IRA is tax-free, which is the big advantage to Roth IRAs.

Conversions – If your modified AGI is less than $100,000, it is possible to convert your traditional IRA to a Roth IRA by paying the tax on the traditional IRA. There are a number of factors to consider when contemplating such a move, such as your current income bracket and resulting tax cost of the conversion, the potential for post-conversion earnings that will result in significant tax-free income and certain estate planning issues.

Under legislation passed in 2006, beginning in 2010, the $100,000 modified AGI limit on conversions of traditional IRAs to Roth IRAs will be eliminated.

Looking ahead, there are some interesting strategies a taxpayer can employ to convert nondeductible traditional IRA contributions to a Roth IRA, thereby funding the more favorable Roth IRA.

• Taxpayers can make nondeductible traditional IRA contributions in the four tax years leading up to 2010, and then convert those nondeductible traditional IRAs to Roth IRAs with virtually no tax, since the nondeductible portion of the IRA can be converted tax-free.

• Taxpayers can convert existing nondeductible IRA accounts to Roth IRAs.

• Taxpayers can roll funds from other qualified plans into a traditional IRA and then roll those accounts into a Roth IRA.

• Where an account includes both nondeductible IRA funds and substantial earnings and/or deductible funds, the earnings and deductible funds can be rolled into a qualified plan leaving only the nontaxable funds to roll (tax-free) into the Roth IRA. Caution: To use this technique, the qualified plan must include the provision to accept IRA rollover funds.

If you would like to discuss your options or develop a Roth rollover strategy, please give this office a call.


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Penalties for Early Distributions from Retirement Plans

Payments that you receive from your IRA or qualified retirement plan before you reach age 59½ are normally called “early” or “premature” distributions. These funds are subject to an additional 10% tax and must be reported to the IRS.

There are a number of exceptions to the age 59½ rule if you make an early withdrawal. Some exceptions apply only to IRAs, some only to qualified retirement plans, and some to both.

In addition to the 10% tax on early distributions, you generally must include the distribution in your income. If you received a distribution from an IRA, other than a Roth IRA, to which you made any nondeductible contributions, the portion of the distribution attributable to those contributions is not taxed. If you received a qualified distribution from a Roth IRA, none of the distribution is taxed. If you received a distribution from any other qualified retirement plan, the portion of the distribution attributable to your cost, not including pre-tax contributions, is not taxed.

A ‘”rollover” is a way to avoid paying tax on early distributions. Generally, a rollover is a tax-free transfer of cash or other assets from an IRA or qualified retirement plan to another eligible retirement plan. An eligible retirement plan is a traditional IRA, a qualified retirement plan, or a qualified annuity plan. You must complete the rollover within 60 days after the day you received the distribution. The amount you roll over is generally taxed when the new plan pays you or your beneficiary.

We highly recommend that you consult with this office prior to taking any distribution from an IRA or any other qualified retirement plan. The tax penalties from a distribution prior to age 59½ can result in taxes and penalties in excess of 40% of the funds withdrawn, and the amount can be close to half for those residing in a place with state taxes. Not a good financial move unless there are no other options. Please call first!


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BUSINESS & MANAGEMENT PRACTICES

Related Party Swap is Tax-Free Despite Post-Exchange Sale

Although tax-deferred like-kind exchanges usually are used to dispose of business or investment property without paying a current tax on realized gain, they also can help related parties rearrange ownership interests on a tax-free basis. As a case in point, a private letter ruling (PLR 200706001) concludes that an exchange of related-party interests in timberland qualifies as like-kind under Code Sec. 1031, even though parties to the exchange immediately sold their interests after the swap is consummated.

Related Party Exchange Rules - A gain or loss on an exchange between related persons generally must be recognized if either the property transferred or the property received is disposed of within two years after the exchange. However, the two-year rule doesn't apply to a disposition if it is established to the satisfaction of IRS that neither the exchange nor the disposition had as one of its principal purposes the avoidance of income tax (Code Sec. 1031(f)(2)(C)).

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Home Not Excludable From Insolvency Exclusion Computation

Tax law generally treats debt forgiveness as taxable income. However, to the extent that a taxpayer is insolvent, debt relief income is excludable from taxable income. To be insolvent, a taxpayer’s liabilities must exceed the taxpayer's assets. Assets excludable under bankruptcy law are generally not included in the assets counted for this purpose.

In a recent tax court decision, a couple who negotiated to extinguish their credit card debt could not exclude the value of their residence, which was exempt under state bankruptcy law, in determining whether they were "insolvent" when the debt was discharged.

The definition of insolvency did not exclude this type of asset. Accordingly, the value of the residence was included as an asset, the couple was not insolvent under the Tax Code, and the discharge of indebtedness income was includible in their gross income.

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GENERAL INFORMATION

Missing a Form 1099?

If you receive certain types of income, you may get a Form 1099 for use with your federal tax return. Form 1099 is an information return provided by the payer of the income. You should receive your Form 1099-series information returns by January 31, 2007. The payer deadline to mail Form 1099-series is January 31, 2007.

Not all 1099-series forms look the same. Many payers will use substitute forms that are with their reports. This is typical of brokerage firms who will include several types of 1099 in a single printed report. So be on the lookout for substitute forms.

If you have not received an expected Form 1099 within a few days after that, contact the payer, to secure the missing information. In some cases, you may obtain the information that would be on the Form 1099 from other sources. For example, your bank may put a summary of the interest paid during the year on the December or January statement for your savings or checking account. If you are able to get the accurate information needed to complete your tax return, you do not have to wait for the Form 1099 to arrive.

Please keep your appointment even if you are missing a 1099 form. We can work around the missing form and you can mail it in at a later date.

Form 1099-series is not a required attachment to your return, except when you receive a Form 1099-R, or Form 1099-INT that shows federal income tax withheld. You will not usually attach a 1099-series form to your return, except when you receive a Form 1099-R that shows income tax withheld. You should keep a copy of all the 1099s that you receive with your tax records for the year. There are several different forms in this series, including:

• Form 1099–B, Proceeds From Broker and Barter Exchange Transactions
• Form 1099–DIV, Dividends and Distributions
• Form 1099–INT, Interest Income
• Form 1099–MISC, Miscellaneous Income
• Form 1099–OID, Original Issue Discount
• Form 1099–R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.
• Form SSA–1099, Social Security Benefit Statement

If you file your return and later receive a Form 1099 for income that you did not fully include on that return, you should report the income and take credit for any federal income tax withheld by filing an amended tax return.

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It's Important to Pay Taxes in Full

Whether paying with a timely filed tax return, or filing and paying late after receiving a bill from the IRS (and we have determined the bill is correct), taxpayers are encouraged to pay the taxes they owe in full. If taxes are not paid, and no effort is made to pay them, the IRS can ask a taxpayer to take action to pay the taxes, such as selling or mortgaging any assets owned or getting a loan. If the taxpayer continues to make no effort to pay the bill, or other payment arrangements have not been made, the IRS could take more drastic measures, such as levying bank accounts, wages, or other income, or taking other assets. A Notice of Federal Tax Lien could be filed that may have a detrimental effect on a taxpayer’s credit standing.

The penalties and interest charged by the IRS are substantially higher than most commercial lending rates, so it is generally better to borrow the funds elsewhere and pay the IRS in full.

Credit Card Payment – Payments can be made by credit card. However, the IRS does not pay the credit card companies discount fees, so that is an additional fee that will be added to your credit card charge. If you are considering paying by credit card to increase your airline miles, forget it. The cost is more than the miles are worth! Payments by credit card can be made through one of two official vendors:

• Official Payments Corporation at 1-800-2PAYTAX (1-800-272-9829) - www.officialpayments.com, or

• Link2Gov at 1-888-PAY1040 (1-888-729-1040) - www.pay1040.com.

Installment Agreement – Taxpayers wishing to pay off a tax debt through an installment agreement, and owe:


• $25,000 or less in combined tax, penalties, and interest can apply for an installment agreement using a simplified procedure.

• More than $25,000 in combined tax, penalties, and interest may still qualify for an installment agreement, but must complete a more complex application including the submission of financial statements.

The IRS user fee for setting up an installment agreement is $105 (was $43 before 2007) if your request is approved and must be paid with the first installment. You will also be charged interest and may be charged a late payment penalty on any tax not paid by its due date, even if your request to pay in installments is granted. Interest and any applicable penalties will be charged until the balance is paid in full.

If you are unable to pay your liability in full, please call this office as soon as possible. Procrastination can lead to further problems, penalties and interest.

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Purchasers of GM and Ford Hybrids Still Qualify for Tax Credit

The Internal Revenue Service announced that purchasers of General Motors Corp. qualified vehicles may continue to claim the Alternative Motor Vehicle Credit. The announcement comes after the IRS concluded its quarterly review of the number of hybrid vehicles sold.

General Motors sold 3,358 and Ford sold 5,645 qualifying vehicles to retail dealers in the quarter ending December 31, 2006.

This brings the cumulative number of qualified General Motors hybrid vehicles sold to 5,558 and 22,156 for Ford. The credit amount and make and model of qualified vehicles sold are:

• Chevrolet Silverado Hybrid 2WD, Model Years 2006 and 2007 - $250
• Chevrolet Silverado Hybrid 4WD, Model Years 2006 and 2007 - $650
• GMC Sierra Hybrid 2WD, Model Years 2006 and 2007 - $250
• GMC Sierra Hybrid 4WD, Model Years 2006 and 2007 - $650
• Saturn Vue Green Line, Model Year 2007 - $650
• Ford Escape 2WD, Model Years 2005, 2006 and 2007 - $2,600
• Ford Escape 4WD, Model Years 2005, 2006 and 2007 - $1,950
• Mercury Mariner 4WD, Model Years 2006 and 2007 - $1,950
• Ford Escape 2WD Hybrid Model Year 2008 - $3,000
• Mercury Mariner 2WD Hybrid Model Year 2008 - $3,000
• Ford Escape 4WD Hybrid Model Year 2008 - $2,200
• Mercury Mariner 4WD Hybrid Model year 2008 - $2,200

Taxpayers may claim the full amount of the credit up to the end of the first calendar quarter, after the quarter in which the manufacturer records its sale of the 60,000th vehicle. For the second and third calendar quarters after the quarter in which the 60,000th vehicle is sold, taxpayers may claim 50 percent of the credit. For the fourth and fifth calendar quarters, taxpayers may claim 25 percent of the credit. No credit is allowed after the fifth quarter.

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Phase-Out Credit for Toyota and Lexus Hybrids Continues

Toyota manufactures the most popular hybrid vehicles and because of their popularity, the hybrid credit is phasing out for hybrids manufactured by Toyota. So, if you are considering purchasing one, you need to act soon.

After reviewing the fourth quarter sales of Toyota Motor Sales USA, Inc., the Internal Revenue Service announced that purchasers of Toyota and Lexus vehicles may continue to claim the Alternative Motor Vehicle Credit. Given the number of vehicles sold, the phase-out period for Toyota vehicles began on October 1, 2006.

Toyota sold 67,857 qualifying vehicles to retail dealers in the quarter ending December 31, 2006. This brings the cumulative sales of qualified Toyota hybrid vehicles sold, from the period of Jan. 1, 2006 through Dec. 31, 2006, to 212,073.

Taxpayers may claim the full amount of the credit up to the end of the first calendar quarter, after the quarter in which the manufacturer records its sale of the 60,000th qualified vehicle. For the second and third calendar quarters after the quarter in which the 60,000th vehicle is sold, taxpayers may claim 50 percent of the credit. For the fourth and fifth calendar quarters, taxpayers may claim 25 percent of the credit. No credit is allowed after the fifth quarter. The sale of Toyota's 60,000th qualified vehicle occurred in the quarter ending September 30, 2006.

Click here for the applicable credit amounts.

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The Downside of Adding Your Child’s Name to the Deed

Many parents, especially the older ones, assume it is wise to add a child’s name to their house deed in case something should happen to them. On the contrary, it is probably the worst thing that can be done. By doing so, the parent creates a host of problems.

• Gift Tax Issue – For gift tax purposes, adding a child to the title constitutes a taxable gift of the ownership interest in the home to the child. If the value of that gift exceeds the annual gift tax exemption ($12,000 for 2006), then a gift tax return must be filed. No gift tax will probably be due if the total of the current and all former gifts is less than $1,000,000, since that is the current lifetime gift exemption for an individual. However, the law requires that the return be filed so that the IRS can track all of the gifts in excess of the annual exemption that an individual makes during his or her lifetime.

• Home Sale Gain Exclusion – Current tax law allows homeowners who meet certain ownership and occupancy requirements to exclude from taxable income up to $250,000 ($500,000 for most married couples) of home sale gain. Thus, if a home deeded to a child is subsequently sold, the home gain exclusion will not apply to the child’s portion unless the child lived in the home for two of the prior five years. This can result in a substantial tax liability, depending upon the value of the home and the child’s ownership portion. Should the parent place the entire property in the child’s name, then generally none of the gain would be excludable and even worse, the parent is at the mercy of the child should the child decide to sell the home. There is no guarantee that the child will continue to care for the parent.

• Debt Liability – Since property is subject to the debts of its owners, and if a child is a part owner, a debtor might file a lien on the property for the child’s debts.

• Medicaid – Gifting the home to a child could, under certain circumstances, be considered a gift for Medicaid qualification purposes, making the parent ineligible for Medicaid benefits in the event of a long-term health crisis.

There are additional issues to consider as well, including the tax ramification to the child based upon the home being a gift or ultimately inherited. Please call this office to discuss these issues in detail before placing your home in any of your children’s names.


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BRIEFS

Are Social Security Benefits Always Taxable?

How much, if any, of your Social Security benefits are taxable depends on your total income and marital status. Generally, if Social Security benefits were your only income, your benefits are not taxable.

If you received income from other sources, your benefits will not be taxed unless your modified adjusted gross income is more than the base amount for your filing status. The following quick computation will determine whether some of your benefits may be taxable:

Step #1 - First, add one–half of the total Social Security you received to all your other income, including any tax-exempt interest and other exclusions from income.

Step #2 - Then, compare this total to the base amount for your filing status.

The base amounts are:
• $32,000 for married couples filing jointly.
• $25,000 for single, head of household, qualifying widow/widower with a dependent child, or married individuals filing separately who did not live with their spouses at any time during the year.
• $0 for married persons filing separately who lived together during the year.

If the amount determined in step #1 exceeds the base amount, then some portion, if not all, of your income will be taxable.

For tax planning purposes, it is important to understand that if your income in Step #1 is at or near the threshold of the base amount, every dollar of additional income will cause more of your Social Security income to be taxable.

If you would like to plan your income so as to minimize the taxation of your Social Security benefits, please give this office a call.

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Ways to Hold Title to Assets

• Held as an Individual – The value of the property will be included in the decedent’s estate, and the property may be passed by will or trust to a named beneficiary. The beneficiary’s basis for any future gain or loss generally will be the fair market value of the decedent’s interest in the property at the date of the decedent’s death.

• Joint Tenancy – The value of the decedent’s interest will be included in the decedent’s estate. The asset cannot be willed to another, and ownership is passed directly to the surviving joint tenants upon death. This may be an unintended result where the joint owner wishes someone else than the joint tenants to be the beneficiary of the property. The surviving joint tenants’ bases in the decedent’s interest in the property will be its fair market value at the time of death. The surviving joint tenants’ bases in their shares of the asset prior to death remain unchanged. Assets held in joint tenancy are not subject to probate proceedings. Another common law form of ownership (available only to married couples) is “tenancy by the entirety,” which receives the same treatment as joint tenancy ownership.

• Tenants in Common – This form of ownership indicates a specific percentage of ownership. The value of the decedent’s interest in the property will be included in the decedent’s estate and is passed by will or trust to a named beneficiary whose basis for any future gain or loss generally will be the fair market value of the decedent’s interest in the property at the date of the decedent’s death.

• Community Property – This title is commonly held by married couples residing in community property states, including California. It permits each spouse to include their half of the asset in their individual wills or trusts and transfer it by will or trust it to any other person. One half of the asset’s value will be included in the decedent’s estate. If the asset passes to the surviving spouse, probate is avoided and the surviving spouse’s basis generally will be the fair market value of the property at the date of death.

• Community Property with Right of Survivorship – Some states, such as California, have a form of ownership known as “Community Property with Right of Survivorship” for married couples. This combines the favorable 100% step up (or step down) in basis feature of community property ownership with the joint tenancy feature of title passing directly to the surviving spouse without probate. One half of the property value at death is included in the decedent’s estate.

If you would like to discuss any of these forms of ownership and how they might affect you tax-wise, please give this office a call.

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