Tax & Business Strategies Monthly Newsletter - November 2006

Tax Planning Strategies
The Benefits & Risks of Margin Accounts
Revising Your W-4? Seek Professional Advice.
When to Deduct Worthless Stock
What are Your Retirement Plans?

Business & Management Practices
Deducting the Home Office
Mixing Business with Pleasure
Computing the Depreciable Basis of a Business Asset

General Information
Computer Donations
Additional Toyota and Lexus Vehicles Certified for the Energy Tax Credit
Education Savings is a New Law Winner

Briefs
Additional Ford Hybrid Vehicles Certified for Tax Credit
Retirement Plan Limit Increases for 2007

TAX PLANNING STRATEGIES

The Benefits & Risks of Margin Accounts

When buying a security on “margin,” you are essentially borrowing money from the brokerage firm and using your investments with that broker as collateral.

Risk Factors – Buying on margin represents a significant higher risk because you are borrowing money to buy the securities. Because of these inherent risks, the margin account agreements give the broker significant latitude in covering declines in margin portfolio equity. They can make cash calls or sell the stock purchased on margin to cover the loan amount.

Example: Assume you paid $50 in cash and borrowed $50 from the broker to buy a $100 share of stock. If that stock increases in value, say to $150 a share, then you made $50 on your $50 investment or a 100% return on investment. Of course, you will have to pay the broker interest for borrowing the other $50. Looking at the other side of the coin, if the stock drops in value to $50, then your entire investment was lost plus interest on the loan.

Margin Calls – The broker’s margin agreement will require that you have a minimum equity in the account. That minimum equity varies with brokerage firms, but can be between 25% and 40%. If your equity in the account drops below the minimum, then the broker will issue a “cash call” for you to deposit sufficient funds to bring the account equity back up to the minimum amount. If you fail to do that, brokers generally have the right, without your permission, to sell the stock purchased on margin to cover the minimum equity.

Deducting the Margin Interest – Margin interest paid is deducted as an itemized deduction. Thus, if a taxpayer does not itemize, he or she is unable to gain any benefit from having paid the interest. In addition, the investment interest deduction is limited to net investment income for the year. Net investment income is all of your investment income less any investment expenses other than the interest for the year.

Example: Assume your margin interest for the year was $700. The only investment income you had was $300 from dividends and you deducted $50 for investment publications, making your net investment income $250 ($300 - $50). Therefore, you can only deduct $250 of the margin interest and the $450 balance carries over to subsequent years.

Be sure you understand the terms of your margin agreement, including interest rates, collateral terms, original, minimum and maintenance margins, and how notice is given before selling your stock to cover a margin call. Read the agreement carefully. It may be a separate agreement or included in the agreement that was originally signed to open the account.


back to top

Revising Your W-4? Seek Professional Advice.

The W-4 form that you provide to your employer establishes the amount of income tax that is to be withheld from your payroll. This form allows you to specify your filing status and the number of dependent exemptions to be claimed on your tax return. This is where a frequent error occurs.

Let’s say that you are married and have two dependents. On your tax return, you claim four exemptions. The natural thing for you to do would be to claim “married” and four exemptions on the W-4. However, for W-4 purposes, the exemption for the taxpayer and spouse are automatically built into the married rates and only two exemptions need to be claimed. The result, of course, is that the taxpayer ends up claiming more exemptions than he or she actually has, which can result in under withholding if the standard deduction is used.

It is common practice and acceptable for taxpayers to claim additional exemptions when they have excessive withholding. The withholding tables do not account for large itemized deductions or other situations that might reduce their taxable income. It also quite common for taxpayers to increase their exemptions to provide more take-home pay from their payroll checks. That might seem like a good idea now, but it could lead to an unexpected tax liability at tax time.

When the IRS believes a taxpayer is not withholding enough, they have a new policy of issuing what is referred to as a “lock-in” letter. If it is determined that not enough tax is being withheld for an employee, a "lock-in" letter will be issued to the employer. The lock-in letter will specify the maximum number of withholding exemptions permitted for the employee. The employee's copy of the letter will explain how the employee can ask the IRS to determine the appropriate number of exemptions within a defined period of time. The employer must forward the copy to the employee or, if the employee no longer works for the employer, respond to the IRS. An employer must make the lock-in withholding rate effective 45 days after the lock-in letter date unless told otherwise by the IRS.

If you wish to change your payroll withholding amount, we urge you to contact this office. We can help you determine the correct number of exemptions to produce the results desired.

back to top

When to Deduct Worthless Stock

What are Your Retirement Plans?

Today’s situation is very different from that of our parents. Increased longevity, soaring health costs, and the demise of the traditional company pension means today’s workers must be far more proactive in planning their own retirement. In 2004, a typical household head approaching retirement had only about $60,000 saved in IRA and 401(k) accounts, which equates to about $400 per month in retirement income.

Your biggest asset may be your home, but remember that you still need a place to live. It has also been commonplace for homeowners to tap into their home equity for new cars, to fund college education, consumer debt consolidation, etc., so your home may not be paid off by the time retirement rolls around. Those with expensive homes might decide to sell and move into less expensive quarters and use the excess for retirement. But don’t forget, if the gain is in excess of the home gain excludable amount, Uncle Sam will be in line for his share of those profits. Another tactic is to employ a reverse mortgage, which allows you to use the equity while remaining in the home. However, typically you only receive about 40% to 50% of the equity from a reverse mortgage based on current interest rates.

Generally, people need between 65% and 85% of their pre-retirement income to have a secure retirement. Less than that may leave you struggling to make ends meet. So, unless you are in line for a big inheritance, you should take a serious look at what retirement has in store for you. Perhaps you should do a retirement needs analysis to see just how much you will realistically need to fund your retirement and at what age you can reasonably plan on retiring.

In addition to simply putting money aside in savings and investments, the tax law offers a variety of retirement benefits through traditional IRAs, Roth IRAs, deferred compensation plans through your employer, and self-employed retirement plans that can help you save for retirement.

Please call today if our office can assist you in establishing your nest egg for retirement.



back to top

BUSINESS & MANAGEMENT PRACTICES

Deducting the Home Office

Taxpayers that use part of their home for business, such as doing paper work, making calls, keeping records, storing materials, inventory or samples, or meeting with customers, may be able to claim a tax deduction for some of their expenses of maintaining the home. However, the rules are far different for an employee and a self-employed individual. Here are the major differences:

• Qualifying for the Home Office Deduction – For an employee to qualify to deduct the expenses of a home office, it must be for the convenience of the employer (i.e., a condition of employment). This requirement is frequently in violation of local labor laws, creates insurance and liability problems, and employers generally will not support a home office. In addition, if the employer already provides the employee with a place to work, then the home office probably will not meet the “principal place of business” requirement of the home office deduction.
  
  For a self-employed individual, the qualifications are far less restrictive since the employee is also the employer. For a self-employed individual to qualify, the home office must be used regularly and exclusively for business and either: (1) be their principal place of business or be used to personally meet with clients or customers in the normal course of their business, or (2) be a separate structure that is not attached to their house or residence, in which case it merely has to be used in their trade or business. The home office deduction is not limited to an office. It can also be used for a workshop, storage area, or other business-related activities. "Exclusive use" means that the business part of the home may not be used for any personal, investment, or other non-business related activities that don't meet the home office qualification requirements.
  
  
• Where the Office is Deducted - An employee is required to deduct the business use of the home (home office) as a miscellaneous itemized deduction on Schedule A. Thus, taxpayers filing with the standard deduction receive no benefit from the home office. Even if they do itemize, miscellaneous itemized deductions are reduced by 2% of the taxpayer’s income (AGI), possibly reducing or eliminating the deduction. Self-employed taxpayers, on the other hand, can deduct the home office directly on their business Schedule C, and the deduction is only limited to the income from the business.
  
  If a taxpayer does qualify for the home office deduction, there are other limitations. There are frequent misconceptions about what is an allowable home office deduction. The deduction is limited only to the portion of the home that is used for business and does not include a portion of the pool upkeep, satellite television, rare antiques and paintings that have nothing to do with the home office environment. In addition, the home office deduction is limited to the income from the activity (cannot create a loss) and is actually in three parts, which must be used in a specified sequence to offset the income. First, the income is offset by the portion of the home interest and taxes attributable to the business activity. Any excess is then deducted on Schedule A. Next, it is offset with office expenses, such as utilities and office repairs. If these expenses exceed the balance of the income, the excess is carried over to the subsequent year. Lastly, the income is offset by office depreciation, and any excess is separately carried over to a subsequent year.

The rules, and there are lots of them, can be quite complicated. If you need assistance in determining if you qualify for a home office deduction, and the amount that can be written off if you do qualify, please give this office a call.



back to top

Mixing Business with Pleasure

It is not coincidental that most conventions are held in resort areas during the spring through early fall months. Convention planners know quite well that convention timing and location is the key to its success. If planned properly, attendees can deduct a portion of the expenses for establishing business relationships and gaining business knowledge while enjoying a mini-vacation. Even without a convention, business travel can be married with some personal relaxation while still providing a partial or complete deduction. It is important to be aware of when the deductions are legitimate as well as when they are not.

Business and Personal Travel

A taxpayer can deduct all travel expenses while away from home if the primary purpose of the trip was business-related. Expenses such as transportation, meals, lodging and incidentals are deductible provided they are not lavish or extravagant. If the taxpayer engages in both business and personal activities while away traveling, he can deduct the transportation expenses in their entirety if the primary purpose of the trip is business- related. Lodging and 50% of meals is also deductible. Where a companion, such as a spouse, accompanies the taxpayer, the companion's meals and travel expenses are generally not deductible. In addition, deductible-lodging expense is based upon the single occupancy rate.

Cruise Ships

Occasionally, conventions will be held on cruise ships. There are special rules related to the deductibility of cruise ship conventions, and the meeting must be directly related to the active conduct of the taxpayer's trade or business. The cruise ship must be a vessel registered in the United States. All ports of call must be located in the U.S. or any of its possessions.

In addition, the taxpayer needs to fulfill stringent reporting requirements, including a written statement providing specific information by both the attendee and an officer of the sponsoring organization. Also, the taxpayer is limited to an annual deduction of $2,000 regardless of how many cruises are involved.

Foreign Conventions

In order to deduct a foreign convention (held outside of North America), the costs need to be 1) directly-related to the active conduct of the taxpayer's trade or business and 2) be just as reasonable to hold the convention or seminar outside the US as it is inside the North American area.


Please note that a higher standard is applied to foreign conventions than to conventions and seminars held within the North American area. Various factors are considered to determine the reasonableness of the location and convention, including, but not limited to, the meeting's purpose, the sponsor's purpose and activities, the residence of the organization's members, the locations of past and future seminars.


back to top

Computing the Depreciable Basis of a Business Asset

The “tax basis” of a business asset is generally the point from which a taxpayer can begin writing off (depreciating) or expensing the cost of the asset. Most think of the “tax basis” as being the cost of the business asset. Cost is included, but the tax basis can be higher or lower than the cost, based upon a number of factors. Usually, the tax basis is equal to the asset's purchase price, minus any discounts or rebates and plus any sales taxes, delivery charges and installation costs.

Let’s say you purchase an office machine for $1,000. With the purchase, you receive a certificate for a mail-in manufacturer’s rebate of $100. The salesperson talks you into purchasing an extended warranty for another $50. The sales tax is 8%. You have the item delivered and installed for another $75. Thus, the tax basis of this item becomes $1,109, computed as follows:

The $1,109 would be depreciated (or expensed using the Section 179 expense election, if otherwise qualified).

Land is never depreciable so when the cost of the business asset includes land, the tax basis must be allocated between land and improvements. Only the improvements are counted for depreciation, but the land is included when figuring the gain or loss when the asset is ultimately disposed of. It is commonplace for the allocation to be based on the property tax assessor’s allocation between land and improvements, but other methods are permitted and may actually yield a higher proportion of the cost allocated to the improvements. When purchasing real property, typical costs will include acquisition costs, such as escrow, title, recording, surveys, legal, accounting, etc. Care must be exercised in analyzing the sale closing documents so that the acquisition costs, deposits, and currently deductible items (such as taxes and interest) are properly separated and accounted for.

Let’s say you purchase a rental property for $250,000. Your purchase costs include escrow, legal, title, and transfer taxes totaling $2,280. In addition, you incurred auto travel expenses of $785 looking for the property and closing title. You also repainted the property and replaced the carpet for a cost of $4,500 before offering the property for rent. The tax assessor’s appraisal shows the land at 40% and the improvements 60%. The depreciable basis would be determined as follows:

Any additional improvements made to the property after acquisition would be depreciated separately and no land allocation made.

Seems simple, right? The examples illustrated are clean-purchase examples without the added complication caused by any of the following:

• Acquired in a tax-deferred exchange – Most frequently associated with real estate, the basis computation of exchanged property can be complicated. Basically, a tax-deferred exchange is an equity exchange that can result in some or none of the gain from the prior property being taxable. Where the replacement property is of equal or greater value, and the taxpayer’s equity in the new property is equal or greater than the equity in the prior property, no taxable gain is incurred. Please call this office prior to entering into any tax-deferred exchange, so that we can determine in advance if there is a likelihood of gain and estimate the basis of the replacement property.
  
  
• Acquired in a trade-in – A trade-in is a form of tax-deferred exchange, and the tax basis is generally the adjusted basis (tax basis less depreciation taken) of the property traded in plus any additional cash paid for the new equipment. The computation can be a little more complicated for vehicles.
  
  
• Acquired by gift - The tax basis for depreciation is the same as the donor's basis at the time of the gift.
  
  
• Acquired by inheritance - The tax basis is generally the fair market value of the property on the decedent’s date of death.
  
  
• Used only partially for business – If you use an asset partly for business and personal purposes, not all of the cost may be depreciated or you may be required to use reduced depreciation rates.

For assistance in planning a business asset acquisition or disposition, please call this office before taking action to make sure there are no detrimental tax ramifications.


back to top

GENERAL INFORMATION

Computer Donations

Frequently, taxpayers wish to donate an old computer to a charitable organization, church or even a local school and want to know how to value the donation. The answer to that question depends upon how the computer was used by the taxpayer. Was it for personal or business use?

If the use by the taxpayer was all personal, then the deduction is the lesser of the taxpayer’s cost of the computer or the fair market value (FMV) of the computer at the time of the donation. FMV is what the computer could be sold for to a willing buyer. Generally, old computers have limited resale value.

If the use was all business, then the taxpayer would have been writing off the cost of the computer by depreciating or expensing it under the special Sec. 179 expense allowance. Keep in mind that a taxpayer can’t deduct an item twice. So if it was already written off for business, then there are no further deductions available for the cost of the computer. If it has not been completely written off, then a taxpayer can scrap it and take the remaining value as a loss from the disposition of a business asset on their tax return, not as charitable contribution (Note that charitable contributions are not allowed on a Schedule C and must be deducted as an itemized deduction).

Regardless of how the computer is disposed of, taxpayers need to remember that a computer’s hard drive may contain some sensitive information which should be deleted prior to disposition. There is software for that purpose; check with your local computer store.


back to top

Additional Toyota and Lexus Vehicles Certified for the Energy Tax Credit

The Internal Revenue Service recently acknowledged the certification of three 2007 model year vehicles by Toyota Motor Sales U.S.A. These are the newly-certified vehicles and their respective tax credits:

• 2007 Toyota Prius - $3,150
• 2007 Toyota Highlander Hybrid 2WD and 4WD - $2,600
• 2007 Lexus RX 400h 2WD and 4WD - $2,200

Caution: The full (100%) credit amount for these Toyota and Lexus vehicles is available to qualifying purchasers through September 30, 2006 only.

Toyota Motor Sales U.S.A. surpassed the 60,000 vehicle limitation. Thus, for vehicles purchased beginning in the fourth quarter of 2006, the credit will be reduced. The applicable credit amounts during the phase-out period for the 2007 model-year vehicles are as follows:

back to top

Education Savings is a New Law Winner

There are two similar but different education savings programs that include tax incentives: the Coverdell Education Savings Account and the Qualified Tuition Program (frequently referred to as the Sec. 529 Plan). Both programs were conceived by Congress to promote savings for education. Each program has its own set of somewhat complicated rules, as do most programs with tax incentives.

Although contributions to these programs are not deductible, they do, however, allow the tax-free withdrawal of earnings (so long as the funds are used for qualified education expenses). However, for the Qualified Tuition Program, this tax incentive was due to expire in 2010, thus making the earnings taxable when withdrawn even for qualified expenses. Since 2010 is just around the corner when considering long-range, education-saving strategies, this was becoming a deterrent for people to invest in a Qualified Tuition Program.

Thus, Congress, in recent legislation, made the tax-free withdrawal provision permanent for Qualified Tuition Programs.

Provided below is a brief comparison of the two programs with a number of salient issues not covered. If you would like more information on either program, please call this office and we will be happy to assist you.

(1) The limit is based upon a combination of gift tax considerations and maximum plan contribution limits that vary from state to state. Generally, the maximum is around $250,000. Individuals can give five years worth of gifts in one year under a special gift tax provision.

If you would like more information or would like to do some education planning, please give this office a call.




back to top

BRIEFS

Additional Ford Hybrid Vehicles Certified for Tax Credit

The Internal Revenue Service has acknowledged the certification by Ford Motor Company that two of its 2005 vehicles meet the requirements of the Alternative Motor Vehicle Credit as qualified hybrid motor vehicles. The tax credit for hybrid vehicles applies to vehicles purchased on or after January 1, 2006. The hybrid vehicle certifications recently acknowledged by the IRS and their credit amounts are:

• Ford Escape 2 WD Hybrid Model Year 2005 $2,600
• Ford Escape 4 WD Hybrid Model Year 2005 $1,950

The 2006 Model Year Ford Escape Hybrid front wheel drive and 4 WD models previously were certified in the amounts of $2,600 and $1,950 respectively.


back to top

Retirement Plan Limit Increases for 2007

The IRS has announced the 2007 cost-of-living adjustments (COLAs) for most retirement plans. These increases are as a result of statutory cost-of-living adjustments. The list below summarizes those frequently encountered by taxpayers as well as unaffected limits and those scheduled for statutory increases under current and prior law.

• Defined benefit plans – The limitation for the annual benefit under a defined benefit plan has been increased to $180,000 (was $175,000 in 2006).
  
  
• Defined contribution plans – The limit for annual defined contribution plan addition has been increased to $45,000 (was $44,000 in 2006).
  
  
• Elective deferrals limit – The limit for various elective deferral plans including 401(k) plans and TSA plans increases from $15,000 to $15,500.
  
  
• Annual compensation limit – The annual compensation limit that can be taken into account for computing the deferrals for various types of accounts increases to $225,000 (was $220,000 in 2006).
  
  
• SIMPLE accounts deferral limit – The maximum allowable deferral under a Simple retirement account increases to $10,500 (was $10,000 in 2006).
  
  
• Age 50 catch-up contribution limits – The age 50 catch up contribution limit remains at $5,000 (the same as 2006).
  
  
• IRA Contributions – The maximum traditional or Roth IRA limit remains at $4,000 (the same as 2006).

back to top