Table of Contents
 

 • Kiddie Tax

 • Alternative Minimum Tax

 • Estimated Tax Payments

 • Energy Tax Breaks

 • Other Tax Ideas

The PPA revises many long-standing rules for deducting charitable gifts. Nevertheless, you can still claim generous deductions for qualified donations.

Generally speaking, you can deduct the full amount of cash contributions made to qualified charitable organizations in 2006. For a non-cash donation, you generally are able to deduct the fair-market value of the property if you have owned it for more than one year.

Tax Action: Charge charitable donations or make online gifts before January 1. As long as a contribution is posted by December 31, it can be deducted on your 2006 return—even if you don’t actually pay off the charge until 2007.

Beginning next year, you will face tighter substantiation requirements for cash donations under the PPA. In addition, another PPA change denies deductions for clothing and household goods donated after August 17, 2006 unless the items are in “good condition.”  Exception: If you obtain an appraisal of more than $500 for a single item, the amount may be deducted regardless of the item’s condition.

Furthermore, the new tax law permits individuals age 70½ or over to take tax-free distributions from an IRA if the funds are donated directly to a qualified charity. The tax-free distributions are capped at $100,000 per year.

Tax Action: Take advantage of this new tax break before year-end. The provision for charitable IRA rollovers is effective only for distributions in 2006 and 2007.

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Previously, the kiddie tax only applied to children under age 14. However, TIPRA raises the threshold for the kiddie tax from age 14 to 18, effective this year.

Tax Action: If a young child’s unearned income is close to the $1,700 mark, you might arrange to have the child invest in short-term obligations that mature in 2007. Alternatively, the child may invest in growth stock that is not expected to produce current income. Another option is to use investments in tax-free municipal bonds or municipal bond funds.

Depending on your circumstances, it may make sense to utilize a Section 2503(c) trust, a Section 529 plan or some other vehicle for saving funds without kiddie tax erosion. We would be glad to provide details upon your request.

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The alternative minimum tax (AMT) was originally intended to apply only to the wealthiest taxpayers. However, it continues to affect a wide range of filers in all income brackets.

How it works: The complex AMT calculation involves certain “tax preference” items, technical adjustments and an exemption amount based on your filing status. When the calculation is complete, the result is compared with your regular income tax liability. Then you effectively pay the higher of the two. The AMT rate is 26% for the first $175,000 of AMT income; 28% on amounts above $175,000.

At least TIPRA preserved slightly higher AMT exemption amounts for 2006 as shown below. The exemption amounts are now scheduled to revert to 2000 levels after this year.

Tax Action: Have your AMT liability assessed before year-end. When it makes sense, you might shift tax preference items to 2007 to avoid the AMT for 2006. Otherwise, it may make sense to accelerate income into 2006 if your regular top marginal tax rate is higher than your AMT rate.

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However, no estimated tax penalty is assessed if you meet one of the following “safe harbors” under the tax law.

• Your annual payments equal at least 90% of your current liability;
• Your annual payments equal at least 100% of the prior year’s tax liability (110% if your adjusted gross income (AGI) for the prior year exceeded $150,000); or
• You make installments on a current basis under an “annualized income” method. This method may be suitable for taxpayers who receive or accrue most of their annual income during a short period during the year (e.g., seasonal sales).

Tax Action: Adjust your withholding at year-end to meet one of the safe harbors. If the adjustment is made after you clear the annual Social Security wage base ($94,200 for 2006), you may increase withholding with little or no reduction in your take-home pay.

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• You may claim a 30% tax credit for installing qualified solar and fuel-cell property in your home.
• You can also claim various tax credits for qualified home improvements, including insulation materials, exterior windows (including skylights) and certain heating/cooling devices. The lifetime limit for these improvements is $500.
• The new law enhances the tax benefits for owners of energy-efficient vehicles. In effect, it replaces the deduction for clean-air vehicles with four new tax credits.

Tax Action: The new tax breaks for energy-saving purchases generally apply to property placed in service after 2005. So this is the first year you can take advantage of the EPACT tax incentives. The energy-saving tax breaks generally expire after 2007.

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Other Tax Ideas

Despite recent tax law modifications, you can still claim a dependency exemption of $3,300 for a child if you provide more than half of the child’s support in 2006. There is no gross income limit for a child who is under age 19 or a full-time student under age 24. Note: The tax benefit of personal exemptions is phased out for certain high-income taxpayers.

When permitted by state law, you might consolidate outstanding personal debts into a home equity debt. Although interest on personal debts is not deductible, you may deduct the mortgage interest paid on the first $100,000 of home equity debt—regardless of the use of the proceeds. Caution: Because the debt must be secured by your home, use this technique with discretion.

Miscellaneous expenses are deductible to the extent that the annual total exceeds 2% of your AGI. If possible, pay these expenses at year-end to maximize your deduction for 2006.

You may claim one of the education tax credits—the Hope Scholarship credit (maximum of $1,500) or the Lifetime Learning credit (maximum of $2,000)—for qualified expenses paid before year-end. However, the credits phase out between $90,000 and $110,000 of AGI for joint filers; $45,000 and $55,000 for single filers.

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For 2006, a qualified domestic producer can deduct 3% of the lesser of its taxable income from qualified production activities or its taxable income (or modified AGI for individual taxpayers). The deduction is scheduled to increase to 6% in 2007 and then to 9% in 2010.

However, this annual deduction is limited to 50% of the W-2 wages paid during the tax year. To qualify for the deduction, production activities must be performed in “significant part” in the United States.

New final regulations issued earlier this year have expanded the activities eligible for the manufacturing deduction and liberalized various other rules. For example, the new regulations make it easier to claim a deduction for construction activities and streamline the methodology for determining qualified production activity income.

Tax Action: Consult with a tax professional to determine any available deduction for your business operation.

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Under MACRS, you can generally deduct the equivalent of a half-year’s worth of depreciation for business assets placed in service before the end of the year—no matter how late in the year it actually occurs. This tax break is called the “half-year convention.” For instance, using the IRS tables for the half-year convention, you can deduct 20% of the cost of new computers placed in service in late December.

Caution: If the cost of business assets (other than real estate) placed in service during the last quarter of the year—October 1 through December 31—exceeds 40% of the cost of assets placed in service during the entire year, depreciation deductions must be computed under the “mid-quarter convention,” which is generally less favorable.

Tax Action: Consider postponing equipment purchases until 2007 to avoid this last quarter tax trap. Alternatively, if your business needs the business assets right away, it can maximize the tax benefits under the Section 179 “expensing” deduction.

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Due to recent tax law changes, the maximum expensing allowance is significantly higher than a few years ago. The maximum deduction for assets placed in service in 2006 is $108,000. (It jumped from $25,000 to $100,000 after 2002.)

Tax Action: Estimate the Section 179 deduction you will be able to claim for the 2006 tax year. If you still have some leeway, you can buy additional assets before year-end. The amounts expensed under Section 179 do not count toward the last quarter tax trap.

Note: The maximum Section 179 deduction was scheduled to revert to $25,000 after 2007. However, TIPRA extends higher inflation-indexed dollar caps through 2009.

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Tax Action: Watch out for limits for so-called “luxury cars.” Under special rules, annual deductions are strictly limited for vehicles purchased at a relatively low cost. Similarly, deductions are effectively limited for leased vehicles.

The IRS adjusts the depreciation limits for luxury cars each year. The figures for vehicles placed in service in 2006 are shown below.

Note: These figures are based on 100% business use. For example, if you place a new car in service in 2006 and use it 80% for business, your first-year deduction is limited to $2,368 (80% of $2,960).

Alternatively, you can choose to use a standard mileage deduction with a built-in depreciation component. The standard mileage rate for 2006 is 44.5 cents per business mile (plus parking fees and tolls). If you use the standard mileage rate the first year of service, you cannot change to the actual expense method in a later year.

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Employee Bonuses

This special deduction rule does not apply to bonuses paid to majority shareholders of a C corporation or certain owners of an S corporation or a personal service corporation.

Tax Action: Have an accrual-basis company fix bonus amounts before year-end. Therefore, the bonuses can be deducted on the company’s 2006 return as long as they are paid by March 15, 2007. Keep detailed corporate minutes to support the deductions.

Note: Recent regulations on “deferred compensation plans,” including bonus plans, impose new requirements on employers. Consult with a tax professional for details.

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Arrange for your company to make charitable donations at year-end. The deductions are generally limited to 10% of the company’s taxable income, but the excess may be carried over for five years.  Note: The PPA extends through 2007 certain tax breaks for charitable donations of food and books by business entities.

Any repairs made by your company before year-end are deductible on its 2006 return. However, capital improvements to the business premises must be capitalized. Try to keep repairs and major renovations separate.

As a general rule, business bad debts can be deducted in the year they become worthless. To support your claims, keep detailed records of collection efforts, including letters, phone calls, e-mails and collection agency activity.

Owners of commercial buildings may benefit from making energy-efficient improvements in 2006. The improvements must be certified as meeting standards spelled out in EPACT.

Deductions for entertainment and meal expenses are generally limited to 50% of the cost to the company. However, this restriction does not apply to a company gathering—such as a party at the end of the year—where the entire workforce is invited.

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1. Traditional IRAs: Contributions are fully or partially tax deductible for the 2006 tax year unless you are an “active participant” in an employer-sponsored retirement plan and your AGI exceeds $85,000 for joint filers ($60,000 for single filers). If your spouse is an active participant and you are not, the deduction is phased out for an AGI between $150,000 and $160,000.

The maximum IRA contribution for 2006 is $4,000. However, if you are age 50 or over, you are permitted to make an extra "catch-up" contribution of $1,000.

Tax Action: The deadline for 2006 IRA contributions is your tax return due date. Nevertheless, you can boost retirement savings by making contributions sooner. This provides more time for contributions to grow on a tax-deferred basis.

2. Roth IRAs: Contributions are not tax deductible, but “qualified distributions” are tax-free. To qualify, you must meet a five-year holding requirement and the distribution must be received after age 59½, upon death or disability, or to pay first-time home-buyer expenses (up to a lifetime limit of $10,000). The ability to contribute to a Roth IRA is phased out for joint filers with an AGI above $150,000 ($95,000 for single filers).

The contribution limits for Roth IRAs are the same as traditional IRAs. If you choose, you can divide your contributions between both types of IRAs, up to the annual limit.

Tax Action: You may convert a traditional IRA to a Roth if your AGI is $100,000 or less. However, you will owe tax on the conversion. If this makes sense for you, try to keep your AGI for 2006 below $100,000 by postponing taxable income to 2007.

Under TIPRA, taxpayers will be able to convert to a Roth IRA in 2010, regardless of their AGI level. The resulting tax can be paid over the following two years.

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As with other qualified retirement plans, a 401(k) plan must meet strict non discrimination requirements in order to maintain its tax-favored status. Also, there is an annual dollar cap on elective deferrals. For 2006, you can defer up to $15,000, plus a “catch-up contribution” of $5,000 if you are age 50 or over, for a maximum annual deferral of $20,000.

Tax Action: Adjust your 401(k) plan contributions at year-end to boost your retirement nest egg. For instance, you may allocate more dollars to your 401(k) account after you clear the Social Security wage base of $94,200.

The PPA includes numerous changes for providers of 401(k) plans and other qualified retirement plans. For instance, it will become easier for employers to establish automatic-enrollment 401(k) plans. The new law also permits plan providers to offer personalized investment advice to account holders after 2006.

Many favorable retirement plan provisions in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) were scheduled to expire after 2010. The new law repeals these “sunset” provisions—including higher contribution and benefit amounts, catch-up contributions for older workers, faster vesting on employer matching contributions and various other enhancements—and makes them permanent.

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Currently, the maximum tax rate on long-term capital gains is 15% (5% for individuals in the regular 10% and 15% tax brackets). Capital gains and losses offset each other. Any excess loss can then offset up to $3,000 of highly taxed ordinary income. Finally, excess loss above the $3,000 figure is carried over to next year. With these basic rules in mind, you may use the following techniques:

• If you have already realized capital gains in 2006, you might realize capital losses at year-end to offset those gains.
• If you already realized capital losses in 2006, you might realize capital gains at year-end to absorb those losses.
• Remember that the holding period for long-term capital gain or loss is more than a year.
• Depending on your personal circumstances, it may make sense to accelerate or postpone security transactions. For example, you might hold on to stocks a little longer to qualify for long-term capital gain treatment for 2006.

Finally, be aware that the “wash sale rule” prevents you from deducting a loss from the sale of securities if you acquire substantially identical securities within 30 days.

Tax Action: To avoid this harsh result, you can (1) wait at least 31 days to repurchase the securities, (2) acquire replacements first and wait at least 31 days before selling the original shares or (3) buy similar (but not identical) securities at any time.

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Despite far-reaching changes under new tax laws enacted in 2006, the federal estate-tax rules did not change this year. Under EGTRRA, the estate-tax exemption will effectively increase to $3.5 million for 2009 before the estate tax is completely repealed in 2010. Furthermore, the top estate-tax rate of 55% is gradually reduced to 45%. However, the estate tax will be revived in 2011 with the top 55% rate unless new legislation is enacted.

Here is the EGTRRA schedule for the rate reductions and exemption increases. 

Tax Action: You may reduce the size of your taxable estate with a series of lifetime gifts. Under the annual gift-tax exclusion, a donor can give each recipient up to $12,000 in 2006 ($24,000 for joint gifts by a married couple).

Therefore, a couple might give a family member up to $24,000 in December and another $24,000 in January. If they do this for 10 recipients, the couple can reduce their assets by $480,000 in just a two-month period without eroding the estate-tax shelter.

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Defer tax on investment income from certificates of deposit (CDs) and Treasury securities by acquiring investments that mature after 2006. Generally, the income from these investments is taxable in the year it is received.

Consider investments in dividend-paying stocks. As with long-term capital gains, the maximum income tax rate on qualified dividends received in 2006 is only 15% (5% for taxpayers in the 10% and 15% regular income tax brackets).

Under the PPA, a non-spouse beneficiary of an inherited qualified plan has more flexibility in stretching out required minimum distributions (RMDs). The new provision for RMDs takes effect for distributions after 2006.

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This year-end tax letter is intended only to serve as a general guideline. Of course, your personal circumstances may require in-depth examination.

Your Somerset CPAs client service professional is available to help you achieve your tax and financial objectives.  Contact us at 317-472-2200 or 800-469-7206 or send a message to info@somersetcpas.com.

Since technical information is presented in generalized fashion in this Tax Letter, no final conclusion on these topics should be made without further review. For additional information on the issues, please contact a member of the firm. This information is not intended or written to be used, and cannot be used, for the purpose of avoiding tax penalties that may be imposed on the taxpayer.

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