Controlling Income
Income can be accelerated into 2009 or deferred to 2010 by controlling the receipt of various types of income depending on your situation, such as:

For Business Owners

• Year-end interest or dividend payments from closely-held corporations;
• Rents and fees for services (delay December billings to defer income); and
• Commissions (close sales in January to defer income).

CAUTION: Income cannot be deferred to 2010 if you constructively receive it in 2009. Constructive receipt occurs when you have the right to receive payment or have received a check for payment even though it has not been deposited. Income also cannot be deferred if you effectively receive the benefit of the income; for example, if you are allowed to pledge a deferred compensation account balance to obtain a loan.

Bonuses for work performed in a particular year can be deferred to the next year if an election is made no later than the end of the year preceding the year the work is to be performed. Accordingly, bonuses for work to be performed in 2010 can be deferred to 2011 if the required election is made before the end of 2009.

For Investors

• Interest on short-term investments, such as Treasury bills (“T-bills”) and certain certificates of deposit that do not permit early withdrawal of the interest without a substantial penalty, is not taxable until maturity. Example: In November 2009, an investor buys a six-month T-bill. The interest is not taxable until 2010 assuming the T-bill is held to maturity.
• Interest on U.S. Series EE savings bonds
  Other than not being taxable until the proceeds are received, interest on issued Series EE bonds may be exempt from tax if the proceeds of the bond are used to pay certain educational expenses for yourself or your dependents, and the requirements of “qualified United States savings bonds” are met.

Planning Suggestion: Consider investments that generate interest exempt from the regular income tax. You must, however, compare the tax-exempt yield with the after-tax yield on taxable securities to determine the most advantageous investment. In addition, some tax-exempt interest may be subject to AMT, which could lower the tax-exempt yield.

Other ways to defer income include installment sales and tax-free exchanges of “like-kind” investment or business property.

Planning Suggestion: If you made a 2009 sale that is eligible for installment reporting, you have until the due date of your 2009 return, including extensions, to decide if you do not want to use the installment method and, instead, report the entire gain in 2009.

2009 Federal Income Tax Rates

For Employees

• Year-end bonuses and deferred compensation

CAUTION: The Service will scrutinize deferrals of income between owner-employees and their closely-held corporations. Also, any deferred compensation arrangements must be entered into before the compensation is earned. Additionally, if you own more than 50 percent of a taxable (C) corporation or any stock of an S corporation that reports on an accrual method of accounting, the corporation can deduct a year-end bonus to you only when it is paid.

Planning Suggestion: The tax rate for the Medicare Hospital Insurance portion of the social security tax is:

• 1.45 percent for employees
• 1.45 percent for employers
• 2.9 percent for self-employed individuals

This tax is imposed on all employee compensation and self-employed income, including vested deferred compensation, without any limitation or cap. If you are a shareholder in an S corporation, you might be able to reduce the Medicare tax by reducing your salary. However, reasonable compensation must be paid to S corporation shareholders for services rendered to the S corporation.

• Distributions from retirement plans

Distributions from qualified retirement plans can be delayed

CAUTION: Penalties may be imposed on early, late or insufficient distributions.

• IRA distributions

Distributions from individual retirement accounts (“IRAs”) can be delayed until age 70½. If you have not reached age 59½ and need to take a distribution from your IRA to pay medical expenses, the ten- percent early withdrawal penalty does not apply to the portion of those medical expenses in excess of 7½ percent of your AGI. However, you will have to pay regular income tax on the entire distribution. If you have been unemployed and received unemployment compensation for at least 12 weeks before age 59½, distributions used to pay any health insurance premiums are not subject to the ten-percent penalty.

If you are planning to purchase a new home, you may withdraw up to $10,000 from your IRA to pay certain qualified acquisition expenses without having to pay the ten-percent early withdrawal penalty. The distribution is still subject to the regular income tax. The $10,000 withdrawal is a lifetime cap. If a taxpayer or spouse has owned a principal residence in the previous two years, this penalty-free provision is not available. An eligible homebuyer for this purpose can be the owner of the IRA, his or her spouse, child, grandchild, or any ancestor. Also, penalty-free distributions can be made from IRAs for higher education expenses of a taxpayer, spouse, child, or grandchild.
 

• Accelerated insurance benefits

Subject to certain requirements, payments received under a life insurance policy of an individual who is terminally or chronically ill are excluded from gross income. If you sell a life insurance policy to a viatical settlement provider (regularly engaged in the business of purchasing or taking assignments of life insurance policies), these payments also are excluded from gross income.

• Educational expense exclusion

An exclusion for employer-provided education benefits for nongraduate and graduate courses up to $5,250 per year is available.

Planning Suggestion: If you wish to take university courses, speak with your employer about paying up to $5,250 of the tuition per year as part of your compensation package. You may also be eligible for an “above- the-line” deduction (deductible in arriving at AGI, regardless of whether you itemize or use the standard deduction) of up to $4,000 for higher education expenses if your AGI does not exceed $65,000 (or $130,000 if filing a joint return). If your AGI is greater than $65,000 (or $130,000 on a joint return), but does not exceed $80,000 (or $160,000 if filing a joint return), your maximum tuition and fees deduction will be $2,000. Once your AGI exceeds $80,000 (or $160,000 on a joint return), a deduction will not be allowed. The $4,000 limit must be reduced for those higher education expenses that are not subject to tax, i.e., United States Government interest used to pay higher education expenses; distributions from state tuition programs (section 529 plans); or distributions from educational IRA plans. The “above-the-line” deduction for higher education expenses is not applicable for taxable years beginning after 2009, unless an extension is enacted into law.

• Educators’ Out-of-Pocket Classroom Expenses in 2009

Eligible educators can deduct $250 (subject to various limitations) of their classroom expenses as above- the-line deductions. These are expenses that would otherwise be allowable as trade or business deductions. The balance of the educators’ classroom expenses is deductible as an unreimbursed employee business expense, a miscellaneous itemized deduction subject to the two-percent-of-AGI floor. This provision is available for taxable years beginning before January 1, 2010.

• Damages received for non-physical injuries and punitive damages

All amounts received as punitive damages and damages attributable to non-physical injuries are gross income in the year received. Legal fees attributable to non-business income or to employment related unlawful discrimination lawsuits are a reduction of gross income, instead of a miscellaneous itemized deduction. Damages received by a spouse, which are attributable to loss of consortium due to physical injuries of the other spouse, are excluded from income.

Controlling Deductions
Itemized deductions, other than investment interest, medical expenses, and casualty or theft losses, are reduced by three percent of the amount by which a taxpayer’s 2009 AGI exceeds $166,800 ($83,400 for married taxpayers filing separately). However, these itemized deductions are not reduced by more than 80 percent of the otherwise allowable deductions. For taxable years beginning in 2009, this reduction of itemized deductions is limited to one- third of the  otherwise applicable reduction. This means that, in 2009, the reduction is one percent of the excess of total itemized deductions over the specified level instead of three percent (assuming that the 80-percent limitation is not applicable). For 2010 the reduction of itemized deductions is eliminated.

CAUTION: Because this reduction of itemized deductions may increase your 2009 marginal tax rate, any decision to accelerate or defer deductions must consider this possible effect.

Deductions that may be accelerated into 2009 or deferred to 2010 include:

• Charitable contributions (cash or property)

You must obtain written substantiation, in addition to a canceled check, for all charitable donations. Charities are required to inform you of the amount of your net contribution, where you receive goods or services in excess of $75 in exchange for your contribution.

If the value of contributed property exceeds $5,000, you must obtain a qualified written appraisal (prior to the due date of your tax return, including extensions), except for publicly-traded securities and nonpublicly- traded stock of $10,000 or less.

Planning Suggestion: If you are considering contributing marketable securities to a charity and the securities have declined in value, sell the securities first and then donate the sales proceeds. You will obtain both a capital loss and a charitable contribution deduction.

CAUTION: If you are contemplating the repurchase of the security in the future, you need to consider the wash sale rules.

On the other hand, if the marketable securities or other long-term capital gain property have appreciated in value, you should contribute the property in kind to the charity. By contributing in kind, you will avoid taxes on the appreciation and receive a charitable contribution deduction for the property’s full fair market value.

If you contribute appreciated, publicly-traded stock (with no restrictions) to a private foundation, you are entitled to a charitable contribution deduction for the full fair market value of the stock.

If you wish to make a significant gift of property to a charitable organization yet retain current income for yourself, a charitable remainder trust may fulfill your needs. A charitable remainder trust is a trust that generates a current charitable deduction for a future contribution to a charity. The trust pays you income annually on the principal in the trust for a specified term or for life. When the term of the trust ends, the trust’s assets are distributed to the designated charity. You obtain a current tax deduction when the trust is funded based on the present value of the assets that will pass to the charity when the trust terminates. This accelerates your deduction into the year the trust is funded, while you retain the income from the assets. This method of making a charitable contribution can work very well with appreciated property.

If you volunteer time to a charity, you cannot deduct the value of your time, but you can deduct your out-of-pocket expenses. If you use your automobile in connection with performing charitable work, including driving to and from the organization, you can deduct 14 cents per mile (this amount stays the same for 2010). You must keep a record of the miles.

The allowable deduction for donating an automobile (also, a boat and airplane) is significantly reduced. The deduction for a contribution made to a charity, in which the claimed value exceeds $500, will be dependent on the charity’s use of the vehicle. If the charity sells the donated property without having significantly used the vehicle in regularly conducted activities, the taxpayer’s deduction will be limited to the amount of the proceeds from the charity’s sale. In addition, greater substantiation requirements are also imposed on property contributions. For example, a deduction will be disallowed unless the taxpayer receives written acknowledgement from the charity containing detailed information regarding the vehicle donated, as well as specific information regarding a subsequent sale of the property.

• Medical expenses

In addition to medical expenses for doctors, hospitals, prescription medications, and medical insurance premiums, you may be entitled to deduct certain related out-of-pocket expenses such as transportation, lodging (but not meals), and home healthcare expenses. If you use your car for trips to the doctor during 2009, you can deduct 24 cents per mile. Beginning on January 1, 2010, you can deduct 16½ cents per mile. Payments for programs to help you stop smoking and prescription medications to alleviate nicotine withdrawal problems are deductible medical expenses. Uncompensated costs of weight-loss programs and diet food to treat diseases diagnosed by a physician, including obesity, are also deductible medical expenses.

Planning Suggestion: If you pay your medical expenses by credit card, the expense is deductible in the year the expense is charged, not when you pay the credit card company. It is important to remember that prepayments for medical services generally are not deductible until the year when the services are actually rendered. Because medical expenses are deductible only to the extent they exceed 7½ percent of AGI, they should, where possible, be bunched in a year in which they exceed this AGI limit. Medical expenses are not subject to the three-percent-of- GI reduction. Under certain conditions, if you provide more than ten percent of an individual’s support, such as a dependent parent, you can deduct the unreimbursed medical expenses you pay for that individual to the extent all medical expenses exceed 7½ percent of your AGI. Even if you cannot claim that individual as your dependent because his or her gross income is $3,500 or more, you are still entitled to the medical deduction. Please consult with a Somerset professional for details. At the time of publication, the United States Congress was considering healthcare legislation that might affect the medical expense deduction. Accordingly, taxpayers should consult with us to determine the impact of any enacted healthcare legislation on the medical expense deduction.

• Long-term care insurance and services

Premiums you pay on a qualified long-term care insurance policy are deductible as a medical expense. The maximum amount of your deduction is determined by your age. The following table sets forth the deductible limits for 2009:

These limitations are per person, not per return. Thus, a married couple over 70 years old has a combined maximum deduction of $7,960, subject to the normal limitation on medical expenses of 7½ percent of AGI.

Generally, if your employer pays these premiums, they are not taxable income to you. However, if this benefit is provided as part of a flexible spending account or cafeteria plan arrangement, the premiums are taxable to you. The deduction for health and long-term care insurance premiums paid by a self-employed individual is covered in the box, “Tax Tips for the Self-Employed.”

Medical payments for qualified long-term care services prescribed by a licensed healthcare professional for a chronically ill individual are also deductible as medical expenses.

• General sales and use tax

For taxable years beginning before 2010, taxpayers may elect to take state and local general sales and use taxes as an itemized deduction, rather than state and local income tax. Taxpayers utilizing this election have the option of deducting actual sales and use taxes paid or using IRS-published tables and then adding the sales tax paid on any “big ticket” item purchases (motor vehicle, boat, aircraft, home).

• Property taxes, mortgage interest, and points

Interest as well as points paid on a loan to purchase or improve a principal residence is generally deductible in the year paid. The mortgage loan must be secured by your principal residence. Points paid in connection with refinancing an existing mortgage are not deductible currently but rather must be amortized over the life of the new mortgage. However, if the mortgage is refinanced again, the unamortized points on the old mortgage can be deducted in full. Additional information regarding mortgage and other interest payments is available herein.

• Interest paid on qualified education loans

An “above-the-line” deduction (a deduction to arrive at AGI) is allowed for interest paid on qualified education loans. The maximum deduction is $2,500. All student loan interest up to the $2,500 annual limit is deductible. However, in 2009 this deduction is phased out for single individuals with modified AGI of $60,000 to $75,000 ($120,000 to $150,000 for joint returns).

CAUTION: Interest paid to a relative or to an entity (such as a corporation or trust) controlled by you or a relative does not qualify for the deduction.

• Non-business bad debts

Non-business bad debts are treated as short-term capital losses when they become totally worthless. To establish worthlessness, you must demonstrate there is no reasonable prospect of recovering the debt. This might include documenting the efforts you made to collect the debt, including correspondence to the debtor to demand payment.

• 401(k) plan contributions

If your employer (including a tax-exempt organization) has a section 401(k) plan, consider making elective contributions up to the maximum amount of $16,500 or $22,000 if over age 50, especially if you are unable to make contributions to an IRA. You should also consider making after-tax, nondeductible contributions to a 401(k) plan if the plan allows, as future earnings on those contributions will grow tax-deferred. A nondeductible contribution to a Roth IRA can also be considered.

Planning Suggestion: If you are a participant in an employer’s qualified plan (which includes a 401(k) plan) and are at least 50 years old, you can elect to make a deductible “catch-up” contribution of $5,500 to the plan. To make a “catch-up” contribution, your employer’s plan must be amended to allow such contributions.

As stated in section 409A, restrictions on the timing of distributions from, and contributions to, deferred compensation plans require most individuals to:

1. Make an election to defer compensation in the year prior to the year in which the services related to the compensation are performed. For compensation earned during 2010 an election would have to be made no later than December 31, 2009.
2. Limit the timing of distributions based on one (or more) of six prescribed times or events as follows:
   a. separation from service;
   b. disability;
   c. death;
   d. a specified time (or pursuant to a fixed schedule);
   e. change in ownership of the company; or
   f. an unforeseeable emergency.

CAUTION: The tax law contains rules to prevent converting ordinary income into long-term capital gains. For instance, net long-term capital gains on investment property are excluded in computing the amount of investment interest expense that can be deducted, unless the taxpayer elects to subject those gains to ordinary income tax rates. Additionally, if long-term real property is sold at a gain, the portion of the gain represented by prior depreciation is taxed at a 25-percent rate. Capital losses are offset against capital gains. Net capital losses of up to $3,000 can be deducted against ordinary income. Unused capital losses may be carried forward indefinitely and offset against capital gains, and up to $3,000 of ordinary income, in future years.

Planning Suggestion: Add up all capital gains and losses you have realized so far this year, plus anticipated year-end capital gain distributions from mutual funds (this amount should be presently available by calling your mutual fund’s customer service number). Then review the unrealized gains and losses in your portfolio. Consider selling additional securities to generate gains or losses to maximize tax benefits.

CAUTION: Do not sell a security simply to generate a gain or loss to offset other realized gains or losses. The investment merits of selling any security must also be considered.

Note: Capital gains and losses are recognized on the trade date, not the settlement date. For instance, gains and losses on trades executed on December 31, 2009, are taken into account in computing your 2009 taxable income. If a security is sold at a loss and substantially the same security is acquired within 30 days before or after the sale, the loss is considered a “wash sale” and is not currently deductible. However, this nondeductible loss is added to the cost of the purchased security that caused the “wash sale.” This will reduce gain, or increase loss, later when that security is sold. Although present tax law significantly limits a taxpayer’s ability to lock in capital gains without realizing the gains for tax purposes, there are still methods by which this can be accomplished. Please consult your Somerset professional for further guidance.

Qualified Small Business Stock
A non-corporate taxpayer is subject to a maximum tax rate of 14 percent on gain from the sale of “qualified small business stock.” To be eligible, the stock must be issued after August 10, 1993, and must have been held for more than five years. The gain eligible for this exclusion cannot exceed the greater of ten times the taxpayer’s basis in the stock or $10 million. A non-corporate taxpayer may also elect to exclude the entire gain from the sale of “qualified small business stock” held for more than six months if, within the 60-day period beginning on the date of sale, the taxpayer purchases “qualified small business stock” having a cost at least equal to the amount realized from the sale. The changes in the long-term capital gain rates did not affect the tax treatment of “qualified small business stock” sales. Your Somerset professional can be consulted for more information.

Dividend Income
Qualified dividend income from domestic corporations and qualified foreign corporations is taxed at the same reduced rate as long-term capital gains for regular tax and AMT purposes. The rate reduction for dividend income applies to qualified dividends received in taxable years beginning on or after January 1, 2003, through taxable years beginning in 2010. Thereafter, these rate reductions are scheduled to sunset and the older higher rates for dividend income and long- term capital gains are scheduled to return.

Planning Suggestion: For taxpayers who are owners of closely-held  corporations or a corporation that was converted to an S corporation, there are some planning opportunities with the new dividend tax rates. Your Somerset professional can be consulted for further guidance. 

Example: Taxpayer T, in the 35-percent bracket, sells machinery in 2009 for a $1 million note payable in 2011. T’s gain is $900,000 ($1 million less $100,000 basis). $800,000 of this gain is due to depreciation recapture. T must report gain as follows:

T must pay tax of $280,000 (35 percent of $800,000) for 2009, even though the note proceeds will not be received until 2011. Moreover, T’s top marginal tax rate for 2009 will likely be higher than 35 percent due to the three-percent-of-AGI reduction of itemized deductions and phase-out of personal exemptions (as modified for 2009).

Planning Suggestion: If possible, an installment seller of depreciable property should structure the transaction to receive enough cash by the due date of the tax return to meet the first year’s tax on the installment sale. In the above example, T should negotiate to receive an installment payment of at least $280,000 by April 15, 2010.

For 2009, taxpayers can contribute up to $5,000 to a Roth IRA (as long as you have compensation for the year at least equal to the contributed amount). Taxpayers age 50 or older can make additional contributions of $1,000. Thus, the limit is $6,000 a year for people who will be age 50 (or older) during 2009. However, the maximum contribution allowance must be reduced by any contributions (deductible or nondeductible) the taxpayer makes to “regular” IRAs.

For single taxpayers, if adjusted gross income is between $105,000 and $120,000, the $5,000 maximum contribution is phased out. Modified AGI in excess of $120,000 prevent a contribution to a Roth IRA for a single taxpayer. For married taxpayers filing jointly, no contribution can be made if AGI is $176,000 or more, and the $5,000 maximum (per spouse) is phased out for AGIs between $166,000 and $176,000. For married taxpayers filing separately, the allowable contribution is phased out for AGIs between $0 and $10,000.

As with regular IRAs, contributions to a Roth IRA may be made as late as the due date for filing your income tax return, excluding extensions. Thus, Roth IRA contributions may be made by most individuals for 2009 until April 15, 2010. Unlike regular IRAs, contributions to a Roth IRA may be made even if the taxpayer is over age 70½, and the taxpayer or spouse has earned income at least equal to the amount of the contribution.

Besides contributing new retirement monies to a Roth IRA, certain taxpayers are eligible to convert their existing regular IRAs and eligible employer plans to Roth IRAs. This right to convert from a regular IRA or eligible employer plan is available for taxpayers (single and married filing jointly) whose modified AGI is less than $100,000 in the year of conversion. Married taxpayers filing separate tax returns are not allowed to convert, regardless of their modified AGI. Starting in 2010, however, the modified AGI limit of $100,000 no longer applies. Thus, in 2010 all taxpayers, regardless of the size of their income or filing status may convert regular IRAs and eligible employer plans to a Roth IRA.

If a taxpayer converts a regular IRA or eligible employer plan into a Roth IRA, the amount that must be included in the distributee’s gross income is the amount that would have been includible in gross income had the distribution not been part of a qualified rollover contribution. A taxpayer converting in 2010 will include one-half of the income from the conversion in 2011 and one-half of the income in 2012 unless an election is made to include all of the income from the conversion in 2010 income. The converted amount is not subject to the ten-percent early withdrawal penalty, provided no distributions are made from the account during the five-year period after the initial conversion.

Planning Suggestion: It may be beneficial to convert an existing IRA into a Roth IRA even though income will be accelerated and taxes will have to be paid. The advisability of converting depends on various factors, including the age of the taxpayer, current tax bracket, whether the taxpayer has funds from other sources to pay the income taxes on the accelerated income, and whether the taxpayer intends to withdraw funds from the account after age 59½, or after 70½. Two of the advantages of converting a regular IRA or eligible employer plan into a Roth IRA are avoiding the minimum distribution rules and avoiding income taxes on distributions after death to the beneficiary of the Roth IRA. Any decision to convert should also consider the estate tax effects.

Additional Planning: Regular IRAs can be converted to Roth IRAs, and vice versa. Roth IRA conversions for a year must be completed by December 31 of that year. If, upon making the Roth IRA conversion, the taxpayer expected to meet all eligibility requirements (modified adjusted gross income of less than $100,000 and a filing status other than married filing separately), but by year end does not, then a failed conversion has been made. In order to avoid additional tax and penalties, the amount converted must be recharacterized into a traditional IRA by the due date for filing your return, including extensions.

Example (1): Individual D makes a $4,000 contribution to a regular IRA in November 2009. D files his 2009 tax return on April 15, 2010. Immediately before filing the 2009 tax return, when the value of the IRA has increased to $4,500, D recharacterizes the account as a Roth IRA. D will be considered to have made a $4,000 contribution to a Roth IRA for 2009. The $500 of appreciation is not treated as a contribution to the Roth IRA.

AMT paid on “timing” preferences and adjustments (such as accelerated depreciation) for prior years is allowed as a credit against a later year’s regular income tax to the extent it exceeds the later year’s tentative AMT. Therefore, this AMT credit cannot reduce the regular income tax below the AMT for that later year.

Generally, nonrefundable personal credits (such as dependent care, elderly and disabled, and education) are allowed only to the extent regular tax liability exceeds the tentative minimum tax, essentially disallowing these credits against AMT. Temporary provisions previously enacted permitting these credits to offset the entire regular and AMT liability have been extended to taxable years beginning in 2009.

Example: T’s 2008 AMT attributable to timing preferences was $80,000. T’s 2009 regular tax is $100,000, and T’s tentative AMT is $70,000. T may reduce the regular tax by $30,000. Generally, T’s remaining AMT credit of $50,000 ($80,000 less $30,000) may be carried forward indefinitely. No carryback is permitted.

Planning Suggestion: In computing the AMT, a taxpayer may claim depreciation for property placed in service in 2001 and thereafter, using the 150-percent declining balance method (switching to straight-line) and using the same recovery periods as regular tax. This may justify a major acquisition of property before the end of 2009.

However, there is a hidden cost to obtaining long-term capital gain treatment from an ISO. The “spread” (the difference between the fair market value of the shares on the purchase date and the option price paid for the shares) must be added into the taxpayer’s AMT calculation for the year the options are exercised. Any AMT attributable to the ISO spread generally is allowed as an AMT credit carryforward to offset regular taxes owed in future years. Thus, any AMT attributable to the ISO is effectively a prepayment of tax, not additional tax.

The Tax Extenders and Alternative Minimum Tax Relief Act of 2008 amended the AMT provisions to provide relief to those taxpayers with AMT attributable to the ISO adjustment. Any underpayment of tax that is outstanding as of October 3, 2008, resulting from such an adjustment, and any interest and penalty associated with such underpayment, will be abated. For those taxpayers who have paid the AMT on ISOs there will be no abatement or refund. Those taxpayers are provided relief in the computation of their minimum tax credit.

Planning Suggestion: If you are planning to exercise ISOs before December 31, 2009, consider deferring the exercise until after that date and sometime before April 15, 2010. Any AMT on such exercise would likely not be due until April 15, 2011, after the required one-year holding period for the stock has been met. At that time the option shares can be sold at long-term capital gains rates, with a portion of the proceeds used to pay the 2010 AMT liability.

If you have exercised an ISO in 2009 and the value of the stock has decreased, consider a sale before the end of 2009. This should reduce the AMT effect. The sale must be to a non-family member and the stock cannot be repurchased for at least 30 days.

Nonqualified Stock Options
When a taxpayer exercises a non-qualified stock option (“NQSO”) that does not have a readily ascertainable fair market value at the time of issuance (generally the case where the option or option stock is not publicly traded), the spread (the difference between the stock’s fair market value and option price) is taxed as compensation income. When the taxpayer sells the NQSO stock, any subsequent appreciation is taxed as long- or short-term capital gain depending upon the stock’s holding period. Because the spread is taxed as ordinary income, taxpayers in the highest marginal federal tax bracket are taxed at 35 percent on the spread.

A child with earned income may claim a standard deduction up to $5,700 and may be eligible for the $5,000 deductible IRA contribution. Therefore, the child may earn $10,700 without paying federal income tax. The child should also consider a contribution to a nondeductible Roth IRA.

Planning Suggestion: If you own a business, consider hiring and paying a salary to your child. This income will be taxed at the child’s rates, and the payment will be deductible by your business. This technique can be used to fund a college education. Of course, the child must perform services to earn the compensation, and the compensation must be reasonable for the services provided. If the child is 18 or over, this compensation will be subject to social security tax. It will also be subject to federal unemployment insurance tax if the child is 21 or older. The child’s compensation could also be subject to state and local income and payroll taxes. A child under age 18 is not required to file a tax return if the child only has interest and dividend income up to $950, has not made estimated payments and is not subject to backup withholding. However, the parents must include the child’s income exceeding $1,900 on their tax return.

CAUTION: A child under 18 who has capital gains or earned income must file his or her own tax return. Estimated taxes may have to be paid during the year if withholding taxes are not sufficient to cover the child’s tax liability.

A child who can be claimed as a dependent on his or her parents’ return cannot claim an exemption on his or her own return. However, the child is allowed a standard deduction equal to $950 or the amount of the child’s earned income up to $5,700, whichever is greater.

If the child is age 18 or older (24 or older if a full-time student, but only if the child’s earned income does not exceed one- half of the child’s support), income exceeding the standard deduction or itemized deductions will be taxed at the child’s rates.

Planning Suggestion: Consider making gifts of growth stock or Series EE bonds (which can defer taxation of the interest until maturity) to a child under age 18 (or 24, if appropriate). These investments can be converted to investments producing current income after the child reaches 18 (or 24, if appropriate). The resulting income will be taxed at the child’s rates rather than the parents’ top rate. Further, parents in the higher tax brackets should consider making gifts of income- producing property to a child who is 18 (or 24, if appropriate) or older to take advantage of the child’s lower tax bracket (see “Year-End Gifts” below).

Planning Suggestion: Because the $1,700 amount applies to each household employee, if possible, try to keep payments to each person below $1,700 per year. You can also give your household employee up to $120 per month for expenses to commute by public transportation without this amount counting towards the $1,700 threshold or being included in the employee’s gross income.

The law provides several safe harbors for determining the minimum estimated tax that must be paid to avoid penalties. In 2009, the safe harbor percentage remains 100 percent of the 2008 tax for individuals with 2008 AGI under $150,000 ($75,000 for married filing separately), but increases to 110 percent of the 2008 tax liability for individuals with 2008 AGI over those amounts. In the converse situation where an individual expects 2009 income to be lower than 2008 income, the individual can avoid penalties by paying estimated taxes for 2009 in an amount equal to at least 90 percent of projected 2009 tax liability.

Planning Suggestion: Deferring a large gain from December 2009 to January 2010 may postpone all or a portion of the federal tax payment on that gain to April 15, 2011. Unless you are subject to AMT, it may be beneficial to pay estimated state income taxes on a 2009 gain prior to the end of 2009 in order to obtain an itemized deduction on your federal 2009 return.

Two other safe harbor exceptions are available to eliminate penalties for insufficient payments of estimated taxes. No penalty will be imposed for underpayment of estimated taxes if the unpaid tax liability for the year (after taking into account any withholding) is less than $1,000. In addition, if your income varies throughout the year, you may use an annualized installment method to reduce or eliminate potential penalties.

The same rules apply to certain estates and trusts.

Planning Suggestion: If you have underpaid an installment of 2009 estimated taxes, increasing a later installment will not completely eliminate the underpayment penalty. However, increased withholding on year-end salary or bonus payments may be used to make up the underpayment. That is because withholding on compensation is deemed paid evenly over all quarters of the year.

In addition to gifts subject to the annual exclusion and the lifetime credit, direct payments of tuition made on another person’s behalf to a university or other qualified educational organization are also excluded from gift tax, as are direct payments of medical expenses to a medical care provider.

Note: You should consider using appreciated property in making gifts. If the recipients are in lower income tax brackets than you, income from the transferred property, including any gain on sale, will be taxed at lower rates.

Planning Suggestion: It is generally unwise to give property that has declined in value. Rather, you should sell the property and realize the tax benefits of the loss.