Yearend Tax Advice

Yule Sale
Here's Some Holiday Tips for Saving Money on Next Year's Taxes

By Richard Rogowski

Aaaaah, the holidays: festive parties, special times with friends and family round the hearth, chestnuts roasting on an open fire . . . and pulling together a year's worth of tax records.

If that thought puts a screeching halt to your budding holiday spirits, try to remember that now — at the end of the year — is when all income earners should start thinking about 2000 by digging up 1999 receipts, investment statements, pay stubs, bonus accounts, stock option records, medical records and child-care receipts.

While the holidays may seem like a terrible time to have the Internal Revenue Service and the N.C. Department of Revenue on the brain, thinking about them now may result in lower 1999 and 2000 taxes.

By the time you read this, Congress will have recessed for the holidays and most, if not all, of the suggested tax reforms put forward earlier this year will be gone by the wayside. Substantial changes in the tax structure have probably fallen victim to disagreements by both parties in both houses, and to the threatened presidential veto that cannot be overridden by the narrow majority held by the Republicans. You can almost certainly forget about the big, complex schemes to eliminate the marriage penalty and estate and gift taxes, as well as the simplest ideas like reducing the tax rates by one percentage point.

What this means is that the landscape for paying federal and state taxes in April 2000 will look pretty much the same as it did in April 1999. So while accountants won't have to interpret many hastily drawn IRS regulations this year, you should still follow the age-old advice to “consult your tax advisor” to make certain that you have taken advantage of every tax saving opportunity. That's what we did to gather these tips:

Estate Taxes

Avery Thomas, a CPA and partner with Thomas, Stout, Stuart, Core & Stuart in Burlington, urges clients to use the end of the year to review their estate planning. Recent congressional action raised the estate tax threshold above which estate taxes are charged to $650,000 in 1999 and $675,000 in 2000 with the threshold increasing each year until reaching $1 million in 2006. Currently, each person can pass along up to $650,000 of assets to beneficiaries free of federal and estate taxes. Thomas points out that many couples commonly leave their assets to each other in their wills, which, while not necessarily a mistake, is not tax prudent when the IRS is looking at the estate size through cold, analytical eyes.

“We find this problem in numerous estates where many assets are in survivorship accounts or in real estate titled by entirety or in retirement plans, annuities, or life insurance policies with a named beneficiary. You should review the provision in your will referring to the unified credit and exclusion amounts. If a married couple leaves everything to each other, there is no tax at the first death, but the first to die is not using their ($650,000) exemption. Verify that each spouse has enough assets in his or her individual name to fully use the maximum exclusion amount,” Thomas advises.

Thomas also points out that many people think of the $650,000 per person as the limit applied at death, when that figure is really a lifetime exemption. Wealthier couples who feel confident they can continue to expand their income can gift away their exclusion during their lifetime, meaning the growth that money could be expected to create can be passed on to the younger generation.

“The questions that worry everyone is `How much is enough to give? How much do I need to set aside for medical expenses and retirement homes?' People are reluctant to start making gifts until they feel confident they have answered these questions. The sooner you start doing it, the better off you are, so most people should consult a financial consultant to see if they can afford the gifts,” says Thomas.

Taxes on Gifts to Relatives

According to Thomas, many people are also confused about North Carolina's gift tax. The state allows up to $100,000 to be passed along tax free, but only if it goes to a direct line relative or step children. After that level, a tax starts at seven percent. “Strangers in blood,” friends who you want to get the money, must pay higher rates. For example, if a dying North Carolina resident wanted to pass along $650,000 to a child, there would be a $10,000 annual exclusion taken, then a $100,000 lifetime exclusion, leaving $540,000 to be passed along. A seven percent tax on that imposed by the state would be $28,950. No federal tax would be due.

If someone wanted to pass along that same $650,000 to a fishing buddy, the state would allow only a $10,000 annual exclusion with no $100,000 lifetime exclusion that is allowed for blood relatives. The state would tax the remaining $640,000 at a 14 percent rate, taking $80,250 for its coffers.

“If you have the ability and willingness to make gifts, then do not let the state tax cause you not to make the gifts, but the tax must be considered,” says Thomas.

Health-Care Expenses

Aaron Spencer, an associate with Maupin, Taylor & Ellis in Raleigh, reminds self-employed clients to look into Medical Savings Accounts, which are used to pay medical expenses when people have high deductible insurance.

“If they know they will have medical expenses coming up, this is a good vehicle to plan. Contributions are deductible if made by the person or by the employer on behalf of the individual, but all of the money withdrawn has to be used for qualified medical expenses,” said Spencer. If the money is withdrawn, but not used for medical expenses, there is a hefty penalty.

A similar program larger employers often have is called “flexible spending.” Employees can choose to deduct a regular amount of money from their paycheck to cover unreimbursed medical expenses. They are not taxed on that withheld money and are reimbursed when they submit bills to their employers.

Employees with flexible spending accounts can sit down now to figure out what medical expenses they may incur next year that will not be covered by insurance or HMOs. For example, someone who knows they will spend $4,000 to put on dental braces or to undergo laser eye surgery in 2000 can spread out the cost of the uncovered medical expenses over 52 paychecks and that money will not be counted in that person's net earnings. One drawback to flexible spending is the program is “use it or lose it,” meaning if the person spends only $3,000 in medical expenses, they have lost that extra $1,000 withheld forever.

Hurricane Loss Deductions

Hurricanes Dennis and Floyd likely will have an impact on the taxes and filing dates for some North Carolinians. The state and the federal government have extended filing deadlines for taxpayers in the affected areas.

Consult your tax advisor to see if you can claim a storm exemption on filing. People who suffered losses from the hurricanes will have to sit down with their insurance checks and their calculators to see what will happen to their personal and business taxes.

Randy Koder, CPA, the tax manager for Daniel Professional Group in Winston-Salem, uses as an example a person who lost a boat worth $20,000, but which the insurance company would only pay off at $10,000, leaving a supposed net loss of $10,000, less $100 because it was a personal loss.

The IRS will allow a write-off of 10 percent of the person's adjusted gross income, so if the person's AGI was $50,000, they would be able to deduct only $4,900 of the $10,000 net loss on their taxes that would be accounted for on Schedule A.

“But, if the boat was income-producing property (such as a boat used exclusively for chartering, or a fishing boat), then you have a new ball game. You don't have to take only the 10 percent loss. You can take the full amount of the loss at the fair market value minus the insurance proceeds, so you would be able to take off $10,000,” says Koder.

Deductions for Home Offices

Congress has greatly helped small business people over the past couple of years by passing some new laws on home offices, but these new rules will do nothing to help the hard-at-work office professional who feels the need to bring work home at night.

For the past several years — since winning a tax court ruling against a doctor who kept a home office in order to store records on his patients — the IRS has strictly governed who can deduct expenses for home offices.

The hard rule was that the office had to be used exclusively for business and the main business had to be conducted in the office. That meant that some professionals such as plumbers and doctors could not deduct expenses for a home office because they make their living working in other people's homes and offices, or in hospitals.

Acting on behalf of the growing numbers of professionals leaving the corporate life by starting from a home office, Congress passed legislation that went into effect in 1999 relaxing that interpretation. Today, home offices can be deducted if they are principally used in the taxpayer's profession or business.

That does not mean, however, that executives who want to do some corporate work from home can set up a home office and deduct expenses for it.

The IRS interpretation of the new law is that the home office must be the main place where the administrative duties of the business are performed. If there is a corporate office where the executive usually goes to work, that probably eliminates any chance of operating a home office.

However, there could be a justification for a home office if the executive runs a side business or a profit-making hobby. For instance, a computer company executive who does Web page design at night and makes a profit doing it probably can make a case for deducting the expenses of a home office.

Alternative Minimum Tax

If there is one universal concern accountants pass along to their clients, it is to beware of triggering the alternative minimum tax. The problem is that even accountants have a hard time predicting when the AMT will be triggered.

The circumstances, formulas and exemptions Congress and the IRS developed to force high-income taxpayers with high deductions to pay some income taxes are so complicated that people who don't keep a constant check on their income might find themselves subject to paying the tax after it is too late to do anything about it.

Among the circumstances that can force taxpayers into paying the AMT are making a large profit from selling stock in one year, taking a large bonus in a single year, and accepting but not exercising stock options until they build up.

“The best thing to do is exercise those options as you go along and don't let them build up if the price of the stock is going gang busters. You find that some of the employees of those Internet-based companies have been caught by AMT when they tried to exercise their options,” says Koder.

Other Tax Tips

u If you are nearing the middle of your home mortgage, figure out how much interest you will owe for the coming year. If you are close to being under the standard deduction, group your itemized deductions into this year.

This strategy of grouping deductions, such as prepaying your January mortgage payment early, giving more to charity this year than you might next year, and prepaying property taxes due in January should put you above the standard deduction for this year.

In 2000, you could take the standard deduction. The following year you could reevaluate your deductions and maybe prepay deductions again.

u Contribute to a Roth IRA immediately after the first of the year, even if it means drawing out $2,000 per person from a savings account and replenishing that money through the year. The Roth accumulates tax free and is almost certainly sure to grow much faster than a savings account.

COPYRIGHTED MATERIAL. This article first appeared in the December 1999 issue of the North Carolina Magazine.