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 • Kiddie Tax

 • Alternative Minimum Tax

 • Estimated Tax Payments

 • Other Tax Ideas

For starters, you may deduct the full amount of your cash donations to qualified charitable contributions. If you donate appreciated property that you have held for more than one year, you can generally deduct the current fair-market value of the property.

New rules: Strict new substantiation requirements apply to monetary gifts (including gifts made with cash or by check or credit card) in 2007. No deduction is allowed unless you maintain a record of the contribution, such as a bank statement, receipt or written communication from the charity. The written communication must show the charity’s name, the date of the contribution and the amount of the donation.

Furthermore, deductions for charitable gifts of clothing and household goods are generally limited to items in “good condition.” This change applies to donations after August 17, 2006. Exception: If you obtain an appraisal of more than $500 for a single item, the amount may be deductible, regardless of this item’s condition.

Tax tip: Charge charitable donations or post online gifts before January 1, 2008. As long as a gift is made by December 31, you can deduct it on your 2007 return—even if you don’t actually pay the charitable organization until 2008.

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The reach of the alternative minimum tax (AMT) continues to expand. It has been estimated that 20 million filers will be subject to the AMT for the first time in 2007.

Basic premise: The IRS requires you to run a separate AMT calculation involving certain “tax preference” items, technical adjustments and an exemption amount based on filing status. In effect, if your AMT liability exceeds your regular income tax liability, you must 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.

After increasing for several years, the AMT exemption amounts have actually declined for 2007. At the date of publication, it is unknown if an extension of the increase in exemption will occur. Even worse, if Congress does not take any action, these amounts will revert to 2000 levels after this year. Also, exemption amounts are phased out for certain high-income taxpayers. The exemption amounts for 2000 to 2007 are shown below.
 

Tax tip: Assess your personal situation before year-end. When it makes sense, you might shift tax preference items to 2008 to avoid the AMT this year. Otherwise, it might make sense to accelerate income into 2007 if your regular top marginal tax rate is higher than your AMT rate. Consult with your Somerset tax advisors.

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This method is available to some taxpayers who receive or accrue most of their annual income during a short period during the year.

Tax tip: When it’s possible, adjust your withholding at year-end to meet one of the safe harbor rules. Usually, it is easiest to qualify under the rule based on 100% (or 110%) of the prior year’s tax liability.

If you make an adjustment after clearing the Social Security wage base ($97,500 for 2007), you can increase the withholding with little or no reduction in take-home pay.

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2. Tax credits:  You may qualify for either the Hope Scholarship credit or the Lifetime Learning credit for qualified higher education expenses. For 2007:
   • The Hope Scholarship credit is equal to 100% of the first $1,100 of qualified expenses and 50% of the next $1,100 of qualified expenses for each of the first two years of higher education. The maximum credit is $1,650.
   • The Lifetime Learning credit is equal to 20% of the first $10,000 of qualified expenses. The maximum credit is $2,000.

   Each credit is phased out at relatively low levels. The phase-out range for joint filers is an AGI between $94,000 and $114,000 ($47,000 and $57,000 for single filers).
   
   Tax tip: Unlike the Hope Scholarship credit, the Lifetime Learning credit cannot be claimed on a per-student basis. Your Somerset tax advisor can help determine which credit, if any, to claim at tax return time.

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Other Tax Ideas

• Take advantage of the energy tax credit for installations in your home. The current tax breaks for energy saving are scheduled to expire after 2007.
• You can deduct your annual unreimbursed medical expenses over 7.5% of your AGI. If you are near the 7.5% mark—or already over it—schedule nonemergency medical and dental visits before year-end.
• In general, you may be able to claim a dependency exemption of $3,400 for a child if you provide more than half of the child’s support in 2007. There is no limit on taxable income of a child 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.
• If state law permits, you can consolidate outstanding personal debts into a home equity debt. Interest on personal debts is not deductible, but you may deduct mortgage interest paid on the first $100,000 of home equity debt, no matter how the proceeds are used. Caution: The debt must be secured by your home, so use this technique carefully.

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If you buy equipment or other assets for your business this year, you can recoup part of the cost through depreciation deductions. Generally, depreciation deductions are computed under the Modified Accelerated Cost Recovery System (MACRS).

Basic premise: You may 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.

However, 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 calculated under the “midquarter convention,” which is generally less favorable.

Tax tip: Postpone purchases to 2008 if you will trigger this tax trap. Alternatively, if your business needs assets in the last quarter, you may want to maximize Section 179 benefits (see below).
 

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Under Section 179 of the tax code, your business may elect to “expense” (i.e., currently deduct) the cost of qualified assets up to an annual limit. However, the deduction cannot exceed the taxable income for the year. Furthermore, the deduction is reduced on a dollar-for-dollar basis for purchases over an annual threshold.

New rules: The new small-business law increases the maximum Section 179 deduction for 2007 to $125,000. (The inflation-indexed limit was originally scheduled to be $112,000.) In addition, the phase-out threshold for the Section 179 deduction is generally increased from $450,000 to $500,000. The limits for recent years are shown below.

Tax tip: Because there is now more leeway under Section 179, you can buy additional assets before year-end. Significantly, amounts expensed under Section 179 do not count toward the last quarter tax trap (see above).

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The IRS allows an employer to deduct 100% of its business travel expenses and 50% of business-related entertainment and meal expenses incurred in 2007. However, the travel and entertainment (T&E) tax rules are fraught with twists and turns.

In particular, be aware of the following points in mind as you look to increase deductions at the end of the year.

• If you use the standard mileage amount in lieu of deducting actual car expenses, you can deduct 48.5 cents per business mile traveled this year (plus related tolls and parking fees). You can generally switch from using the standard mileage method in the prior year to the actual expense method this year, but not the other way around.

• Under the “luxury car” rules, the deduction limit for a passenger vehicle placed in service in 2007 is $3,060 ($3,260 for light trucks and vans). Note: These figures are based on 100% business use and must be adjusted accordingly. For example, if you use a new car 80% for business, your first-year deduction is limited to $2,448 (80% of $3,060).

• You can only deduct entertainment expenses that are “directly related to” or “associated with” your business. For instance, if entertainment follows or precedes a substantial business meeting, it may qualify as associated-with entertainment. You might want to plan year-end entertainment with clients around such meetings.

• If you give clients business gifts during the holiday season, the deduction is limited to only $25 per recipient. However, if you give gifts of tickets to sporting events, concerts or plays, you may deduct the cost as entertainment (subject to the 50% limit). 

Tax tip: The IRS often challenges T&E deductions, so make sure you comply with all the recordkeeping rules. An employer may avoid complications by establishing an “accountable plan.” Contact your Somerset tax advisor for details.

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Manufacturing Deductions

A 2004 tax law created the “manufacturing” deduction for certain domestic producers of goods. The deduction may be claimed by C corporations or allocated to shareholders or partners in pass-through entities. It is also available to sole proprietors.

New rules: Previously, the deduction was equal to 3% of the lesser of taxable income from qualified production activities or taxable income. The maximum deduction percentage increases to 6% in 2007. It is scheduled to top out at 9% in 2010.

The annual deduction is limited to 50% of the W-2 wages paid during the year. This 50% limit applies only to wages paid in connection with a qualified production activity.

Tax tip: The manufacturing deduction has a wider application than many taxpayers think. It may apply to businesses that are not traditionally viewed as manufacturers. Obtain professional guidance with respect to your situation.
 

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A business may be able to claim certain tax credits for expenses incurred during 2007. The credits are combined in a general business credit on your company’s return.

New rules: The Tax Relief and Health Care Act of 2006 extends and enhances two key business credits that had technically expired after 2005.

1. Research credit: The research credit is generally equal to 20% of your qualified research activities. However, a business may elect to claim an alternative incremental credit based on a stated percentage of average expenses over a four-year period. The new law increases the stated percentages and creates an alternative simplified credit for 2007.

2. Work Opportunity Tax Credit: For 2007, the 2006 law combines the two credits—the Work Opportunity and Welfare-to-Work tax credits—for hiring workers from disadvantaged groups. The new small-business law also broadens the groups to include disabled veterans and more high-risk individuals and extends the credit into 2011.

Tax tip: As things stand now, the research credit is scheduled to expire after 2007 (although it may be extended again). To be on the safe side, your business may wish to incur qualified expenses before the end of the year.

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• If the cost of your goods is rising, consider a switch to the LIFO (Last In, First Out) method of inventory accounting. The change can result in a larger deduction for the cost of goods sold. This will result in a lower taxable income for your company.
• Arrange charitable donations before 2008. Deductions are generally limited to 10% of an employer’s taxable income, but any excess may be carried over for five years. Note: Certain tax breaks for charitable gifts of food and books will expire after 2007.
• Repairs made by your company before year-end are deductible on its 2007 return. However, capital improvements to the business premises must be capitalized. Try to implement separate plans for repairs and major renovations.
• Any loss claimed by an S corporation shareholder is limited to the basis in the stock plus outstanding debt. So shareholders might make a capital contribution or lend money to the corporation before year-end. This increases your basis for loss deduction purposes.
• Owners of commercial buildings may benefit from making energy-efficient improvements this year. The improvements must be certified as meeting certain environmental standards. Note: This tax break is scheduled to end after 2007.

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At the end of the year, you have a unique tax opportunity to time capital gains and losses from securities sales. However, this year you face new tax complications.

As before, capital gains and losses offset each other to produce a net capital gain or loss. Any excess loss can then offset up to $3,000 of high-taxed ordinary income. (If a loss exceeds $3,000, the excess is carried over to next year.) The maximum tax rate on net long-term capital gain is 15%; 5% for those in the regular 10% and 15% tax brackets.

Thus, if you have already realized capital gains in 2007, you might realize capital losses at year-end to offset those gains. On the other hand, if you are showing a net capital loss, capital gains realized at year-end are tax-free up to the amount of the loss.

New rules: The maximum 5% tax rate for long-term capital gains for lower-income taxpayers drops to zero for 2008. Consider the following year-end ideas:

• If you will be eligible for the 0% tax rate in 2008, defer capital gains to next year.

• If you will not be eligible for the 0% tax rate in 2008, you might give gifts of stock to other family members (e.g., young children) who will qualify for this tax break.

• If your child will be eligible for the 0% tax rate in 2008, but the kiddie tax will probably be triggered, you may have the child realize capital gains before year-end.

Tax tip: Due to the changes in the kiddie tax rules for older children, these tax-timing techniques should reflect your family’s overall situation. Finally, you must take all economic factors for security transactions—not just taxes—into account.
 

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There are two main types of IRAs designed for retirement savings: the traditional IRA and the Roth IRA.

1. Traditional IRAs: Contributions are tax-deductible unless you are an “active participant” in an employer-sponsored retirement plan and your AGI exceeds a certain level. For 2007, deductions are phased out for an AGI between $83,000 and $103,000 for joint filers ($52,000 and $62,000 for single filers). If your spouse is an active participant and you are not, the deduction is phased out for an AGI between $156,000 and $166,000.
   
   The maximum IRA contribution for 2007 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 tip: The deadline for 2007 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.

New rules: An individual age 70½ or over can take tax-free IRA distributions of up to $100,000 for gifts directed to a qualified charity. This tax break expires after 2007.

2. Roth IRAs: Contributions are not tax deductible, but withdrawals after five years may be tax-free. To qualify, distributions 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 for 2007 is phased out for joint filers with an AGI between $156,000 and $166,000 ($99,000 and $114,000 for single filers).

The contribution limits for Roth IRAs are the same as for traditional IRAs. If you choose, you may allocate contributions to both types of IRAs, up to the total annual limit.

Tax tip: You may convert a traditional IRA to a Roth IRA if your AGI is $100,000 or less. However, you must pay tax on the conversion. If this meets your needs, try to keep your AGI for 2007 below $100,000 by postponing taxable income to 2008.

New rules: Beginning in 2010, you can convert to a Roth IRA, regardless of your AGI level. For a conversion in 2010, the resulting tax can be paid over the following two years (2011 and 2012). Therefore, it may be advantageous to postpone a conversion.

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A 401(k) plan allows you to defer your salary to an account where the funds can grow tax-deferred. In addition, your company may provide matching contributions.

As with other tax-qualified retirement plans, a 401(k) plan must meet strict nondiscrimination requirements to maintain its tax-favored status. Furthermore, there is an annual dollar cap on elective deferrals. For 2007, you can defer up to $15,500 to your account, plus you can make a catch-up contribution of $5,000 if you are age 50 or over. Thus, the total maximum annual deferral for 2007 is $20,500.

Tax tip: Adjust your 401(k) plan contributions at year-end to increase your retirement nest egg. For instance, you might want to defer more dollars to your 401(k) account after you clear the 2007 Social Security wage base of $97,500.

New rules: The Pension Protection Act of 2006 liberalized many of the tax rules pertaining to 401(k) plans. For instance, it will become easier in 2008 for employers to establish automatic-enrollment 401(k) plans. Beginning in 2007, plan providers are permitted to offer personalized investment advice to 401(k) account holders.

Furthermore, nonspouse beneficiaries who inherit 401(k) plan assets now have greater flexibility. Effective for 2007, a nonspouse beneficiary can roll over the assets to an IRA the same as a spousal beneficiary. Subsequently, the beneficiary can stretch out required minimum distributions (RMDs) over a period of time.

Finally, many favorable tax provisions for 401(k) plans and other tax-qualified plans that were scheduled to “sunset” after 2010 have been made permanent.

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The massive Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) will continue to affect estate-planning techniques over the next few years. For starters, 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 a top 55% rate unless additional legislation is enacted.

Following is the tax law schedule for the rate reductions and exemption increases.
 

Tax tip: 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 2007 ($24,000 for joint gifts by a married couple).

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• Under the “wash sale rule,” you cannot deduct a loss on securities sales if you acquire substantially identical securities within 30 days. To avoid this result, you can (1) wait at least 31 days to repurchase the securities, (2) acquire replacements and wait at least 31 days before selling the first shares or (3) buy similar (but not identical) securities.

• From a tax perspective, it is generally beneficial to sell mutual fund shares before the fund declares dividends at year-end (the “ex-dividend date”) and to buy shares after the date the fund declares dividends.

• Defer tax on investment income from certificates of deposit (CDs) and Treasury securities by acquiring investments that mature after 2007. 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 2007 is only 15% (5% for taxpayers in the 10% and 15% regular income tax brackets).

• If you are purchasing mortgage insurance, pay the premiums before year-end. Some individuals may be able to deduct the cost of premiums paid in 2007.
   

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This year-end tax planning letter is intended only to serve as a general guideline. Of course, your personal circumstances may require in-depth examination. We would be glad to schedule a meeting with you to provide assistance with your tax-planning needs. Please contact us.

This information is provided by Somerset CPAs for our clients and other interested persons upon request. Since technical information is presented in generalized fashion, no final conclusion on these topics should be made without further review. This document 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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