Tax Newsletter 2000
Tax Tricks & Tips
Washington is gridlocked again, as four years ago. The republican Congress is holding Clinton’s programs hostage to the 2000 elections, which it hopes will bring a republican President. Congressional campaigners will lure voters in 2000 with fresh tax cuts, which voters would poorly remember from 1999 so far in advance. Congress will continue to debate all the tax cuts from 1999’s tax gridlock.
Congressional held tumultuous hearings in 1997 and 1998, then passed major tax reforms. The systemic IRS reforms are some of the biggest since 1954 (see page 2). The Taxpayer Relief Act of 1997’s tax changes are the biggest in a decade, and will phase-in for years to come.
Child oriented tax phase-ins include $500 child tax credit (from $400), education loan interest deductible to $1,500 (from $1,000), as well as tax credits unchanged from 1998. But these benefits phase-out at higher income levels, and many of my clients will not get them.
Defer earnings on prepaid tuition, and transfer taxability to your children’s lower bracket with California’s Golden State ScholarShare Trust (www.scholarshare.com). There are no income phase-outs. If your children cannot withdraw all the funds to attend college, you must eventually pay the tax on earnings yourself. At least you have deferred the tax, but you may be in a higher tax bracket.
You qualify for the dependent care tax credit when you pay to send your child to summer day camp.
Contribute your old car (or other non-business property) to charity. Deduct the car’s full retail value, which is usually more than you can get without investing substantial time and expense to sell it. Take pictures and keep maintenance records to document the car‘s value. If the value is over $5,000, you must attach an independent appraisal to your tax return.
Rent your vacation home less than 14 days a year. You do not even have to report the income. If the rental is more than 14 days a year then report all the income, and allocate expenses.
Skyboxes are the alumnus’ tax shelter. IRS allows most of the contribution to your alma matter as a charitable gift deduction, even when you get valuable skybox usage as a side benefit.
Health insurance phases-in to 60% deductibility (from 45%) by the self employed. Better yet, hire your spouse. He/She qualifies you (her/his spouse) for full health insurance coverage. The deduction is on Schedule C, saving additional self employment (ie, payroll) taxes.
Hire your children, who avoid tax completely up to their $4,300 standard deduction. The earned income qualifies them to contribute to an IRA. A Roth IRA is probably better, since they are so young. If you are self-employed, they are exempt from FUTA payroll taxes until they reach 21 years of age, and from FICA until 18.
Home office deductions are back. Congress changed the law after IRS and the courts took the prior highly restrictive law too literally. Many more self employed people can again deduct home depreciation, utilities, insurance, etc. Beware that your home office does not qualify for the generous $500,000 (joint) gain exclusion on sale.
First year depreciation deductions on personal property phase-in to $19,000 (from $18,500). Standard auto mileage goes down for the first time in memory to 31¢/mile, but returns to 32½¢ in 2000.
Meals for employers’ convenience are fully deductible. Avoid the 50% haircut if you have a good business reason to feed your employees. A recent court case (Boyd Gaming) allows the full deduction when the primary business reason for the meal is that employees must stay at work.
Stock options have fueled the hyper growth in Silicon Valley. The big tax planning opportunities include evening out your income over the years, and minimizing AMT. AMT preferences include the built in gain on incentive stock options, and California tax. Tax planning can pay big dividends for anyone with substantial stock options (see AMT, page 2).
Mutual fund investors take care to choose wisely. Expenses range from less than .2% in the broad index funds to more than 5% in specialized funds. Tax managed funds limit trading to limit the tax you must pay. Beware the December ex dividend date, when owners of record receive distributions for the full year. You might convert ordinary income to capital gain, or vice versa, by trading just before or after this date.
Exchange funds allow wealthy investors to defer tax by exchanging (swapping) low basis stock for shares in the fund. Diversify and defer tax until you sell the fund shares. The investment managers charge a healthy fee. Minimum exchange investment is about $500,000. Many politicians consider this a loophole for the wealthy, and are trying to plug it.
The lifetime exclusion increases to $650,000 in 2000 (from $625,000 in 1999). A trust (living or testamentary) doubles the exclusion for a married couple, while retaining the principal and income for the second to die. Everyone should have a trust and/or will.
Contribute a conservation easement on real property to charity. Deduct the value of the gift. Get a current charitable deduction. Lower your estate taxes.
Private annuities help you to pass your property to a future generation. They are especially useful for property that is likely to spurt in value, such as prime real estate, even common stock.
Roth IRAs are one of the biggest and most underused of the new tax saving tricks. You can contribute $2,000 per year of your earned income to a new Roth IRA. You cannot deduct the contribution as with a regular IRA, but you never pay tax on the earnings. The big savings are for younger people, whose IRAs will grow over many decades, and for those who will be in a higher tax bracket when they would distribute their regular IRA.
Convert your traditional IRA to a Roth IRA by December 31. Pay tax on the built-in gain. Your adjusted gross income must be less than $100,000. Conversion is a great estate tax planning tool, since your heirs will not pay income tax, either. Start your Roth IRA now to start the 5 year prohibition on withdrawals (even if you make more contributions later).
Recharacterization of your Roth IRA conversion back to a traditional IRA can be extremely beneficial in the right circumstances. You might want to recharacterize if your income was above the $100,000 limit (or might be, in an audit). Or if your Roth investments have declined substantially. Or if you deferred ¾ of the income until 1999-2001, and you now estimate that your taxable income in these years will be much higher than you anticipated. Or if your estate planning goals have changed the economic calculations. You must recharacterize by December 31.
True Tax Reform
Congress has reformed the IRS, not just the tax structure. Every decade or so politicians make a major tax change (see page 1). Congress last reformed IRS in 1954. Now, almost half a century later, Congress has reorganized management, legislated many taxpayer rights, and outsourced computer modernization. This is true tax reform.
We are fundamentally changing the IRS, says the new IRS Commissioner Charles O Rossotti. Rossotti is the first commissioner with a five year term, making him independent of the President; a civil servant, not a political appointee. He is a highly experienced high tech manager, not a tax lawyer. Rossotti says that we are working to put service first. We are trying to [put] at least as much emphasis on making sure taxpayer rights are preserved, and making enforcement a last resort rather than a first resort.
Congress held tumultuous hearings in 1997 and 1998 that exposed severe IRS problems. Congress legislated many taxpayer rights, including mandatory identification of IRS letter writers, explanation and reconsideration of interest and penalties, appointments of an Oversight Board of Directors and a more independent National Taxpayer Advocate, better treatment of IRS whistleblowers, and vastly increased protections and privacy in audits and collections.
IRS needs to break out of its technological time warp from the 1950s and 1960s says Rossotti. Congress is modernizing IRS, again. Previous IRS management wasted $4 billion of an $8 billion budget in an aborted attempt to redesign its archaic computer system. This time Congress and IRS will outsource potentially the biggest nondefense contract in US history. IRS just chose Computer Sciences Corp to head a team of private companies that will help IRS modernize its computer systems.
IRS is the largest processor of information in the world. One day IRS will have all your information in one place, just like the credit card companies and airlines have done for years. IRS is in the beginning stages of reorganizing itself along functional lines (individuals, small business, large business, and tax exempts), instead of regionally. IRS hopes it will apply the rules more fairly, and that its up-to-date computer systems will not break down. One day, Big Brother will be much more efficient.
What about Y2K? IRS has spent more than $1 billion to patch its existing, archaic, computer systems. Commissioner Rossotti says to keep your fingers crossed.
Taxpayers are being denied the benefits of the law, says IRS National Taxpayer Advocate W Val Oveson. IRS has many teething pains implementing Congress’ policies to be kindlier and gentler. Some of the easy changes it has already made include:
■ Saturday office hours, special problem solving days, and 24 hour telephone help.
■ Lowering in-person audit rates substantially. Instead, IRS computer matches more and more information from the important tax documents such as 1099s which businesses file. Mismatches prompt IRS to bill you for the additional tax. Most of these bills are wrong, at least in part.
■ Web site with forms, instructions, publications, and simple calculators (www.irs.gov). No online filing directly with IRS, yet.
■ Elimination of audit and collection quotas, which IRS has continued to use despite repeated Congressional prohibitions.
Don’t change the tax laws so much (IRS National Taxpayer Advocate W Val Oveson). Every year Congress makes hundreds of tax changes. Many of the changes come too late for IRS to implement them efficiently. This year, for example, Clinton plans to sign 1999’s small tax law on December 17. Every decade or so Congress’ major tax reforms change basic concepts of equitably measuring income and applying tax. You add all these things up and the IRS can’t handle it (House Ways and Means IRS Oversight Chair, Rep Amo Houghton).
Congress and IRS are struggling with major equitable and administrative issues, such as the American Institute of Certified Public Accountants’ top ten complicated tax issues:
1) Alternate minimum tax (AMT), that Congress implemented to tax only the very highest income tax avoiders. But 9% of all taxpayers will pay AMT by 2008 (up from 1% now), an increase of 30% per year. Many more are close to paying AMT, and must plan for it. Some Politicians complain that AMT is an overly complex aberration that must be corrected. Some see AMT as an equitable way to tax the rich. Some even see AMT as true tax reform.
2) Earned income tax credit, that helps the poor. IRS requires multiple worksheets, checklists, and forms. Tax cheats have had a field day with quick, fraudulent, refunds that IRS can hardly retrieve. Now IRS double checks and delays refunds to catch the honest mistakes as well as the tax cheats.
3) Phase-outs based on income raise taxes on higher income taxpayers without raising rates. There are hundreds of separate phaseout limits.
4) The marriage penalty requires different calculations based on marital status in 63 parts of the tax code. These marriage based differences have been around for decades. Significant reforms pose major equity and budget issues.
5) Independent Contractors. Congress has prohibited IRS from making definitive rules to distinguish employees from independent contractors. Congress still has not resolved these issues. A common law 20 factor test is all the guidance we have to determine who should be an employee. Worse, there are seven different Federal and California jurisdictions that commonly interpret the tests differently.
6) Kiddie tax. IRS has 20 pages of instructions and worksheets to figure the tax due. The rules are designed to limit a few wealthy families from saving tax with their children under 14 years.
7) Estimated Taxes. Taxpayers with 1999 Adjusted Gross Income (AGI) over $150,000 must pay at least 105% of 1988’s tax to escape the underestimate penalty. As if this rule were not complicated enough, 2000’s rate goes up to 108.6% of 1999’s tax.
8) Child credit. The $500 per child tax credit is one of the biggest recent tax expenditures for low and middle income taxpayers. There are many side calculations and limitations, including AMT and the phase-out for those with incomes over $110,000 (joint).
9) Generation skipping tax. Every generation must pay its Estate tax, which maxes out at a little over 55%. Your estate must make many complex calculations if you do not give assets directly to your children, and future generations might inherit them directly.
10) Half year and other odd rules. Pension penalties apply before age 59½. Residential depreciation spans 27½ years. Pay at least 108.6% estimated taxes (above). Most people hire a professional tax preparer. If you do-it-yourself, pray that God works for your software company.
It’s gobbledygook (Harold Tanyzer, retired Professor of reading). When over half our individual taxpayers have so little comprehension of, or faith in, their tax system, something is not right. The end result is erosion of voluntary compliance. It is only human to disobey a law if you do not or cannot understand the rules (Tax Executive AICPA Chair David Lifson).
IRS is always trying to identify and to plug loopholes. Congress keeps taxes so complex that there is no end to loopholes. Of course, your loophole is my equitable tax benefit.
Stock options and employee stock purchase plans are growing rapidly. IRS rulings have exempted many of these perks from payroll tax as far back as 1971. Now, IRS has changed its mind and wants the payroll tax.
Family trusts are often scams to avoid recognizing income and to deduct normal living expenses. IRS will audit more trusts, and threatens healthy penalties.
Split dollar life insurance is a scam, says IRS. This scheme uses charities’ tax exempt status to deduct premium payments and to shelter investment income for future generations. IRS threatens charities that participate with revocation of their exempt status.
Used car donations can be scams. A few charities commit tax fraud by colluding with donors to exaggerate the value of the donated cars. Some charities earn only pennies on the donated dollar after paying unconscionable fees to the used car dealers and towing companies that do the work. IRS threatens some of these charities with revocation of their exempt status.
IRS wants more tax from charities’ business activities. Taxpaying businesses complain that charities unfairly compete by not paying income taxes under the guise of their charitable exemptions. Charities respond that their activities, including fund raising, merely serve their constituencies and their tax exempt purpose.
Some charities are quite aggressive. For example, IRS audited AARP and collected $135 million for the years 1985-1993. Since 1994 AARP is paying $15 million per year pending settlement of the continuing dispute.
Congress is trying to lock the barn door on corporate tax shelters. We are convinced of the need for a new approach to block corporate tax shelters (Deputy Treasury Secretary Lawrence Summers). There is not going to be much left of the Corporate income tax the way things are going. The capital gains tax for corporations is essentially elective these days because of the growing proliferation of corporate tax shelters (Michael Schler, prominent tax attorney).
William M West offers tax and accounting services to closely held businesses, attorneys, real estate investors and developers, and individuals. He is experienced with computer systems, and develops computer solutions for business.
December 10, 1999 © William M West This Newsletter is an overview of the year's tax news, and is not tax or legal advice. You should consult a professional to determine how these new and rapidly changing topics affect you and your situation. You may use any material herein if you credit me by name, telephone, address, and issue date; and send me a full copy of your publication.
William M West Certified Public Accountant
Last Updated 1-17-01