Tax Tips
Should you deduct sales tax or income tax?
Last year’s American Jobs Creation Act gave taxpayers who
itemize the option of deducting state and local sales taxes
instead of state and local income taxes on their federal
returns. The deduction is available only through 2005, but
legislators are considering making it permanent.
Deciding which state taxes to deduct is simple in theory:
Whichever taxes you paid more of will yield the biggest
federal tax savings. If you live in a state that has a sales
tax but no income tax, the answer is obvious. For everyone
else, however, it’s a closer call.
For most people, the income tax deduction will continue to
be the better choice, unless you make a large number of
taxable purchases this year or buy big-ticket items,
including luxury vehicles and mobile homes.
You have two options for calculating your sales taxes:
- You can track your actual
expenses — which means holding on to sales receipts and
register tapes for every purchase you make this year, or
- You can use the IRS’s Optional
State Sales Tax Tables (Publication 600), which estimate
average consumption by taxpayers in each state according
to income level and number of exemptions.
Even if you rely on the IRS tables,
you can still add in actual sales taxes for certain items
the IRS has authorized, such as:
- Motor vehicles,
- Boats,
- Aircraft,
- Homes, and
- Home-building materials.
If you live in a state without an
income tax, figure out how much sales tax you paid so you
can deduct these taxes on your federal income tax return.
Even if you didn’t itemize last year, adding in sales taxes
may be enough to allow you to itemize this year.
If you pay state and local income taxes, track your sales
taxes as well — at least on big-ticket items — to see
whether the sales tax deduction would improve your tax
outlook. •
Beware of new tax requirements for signing bonuses
If you require workers to sign an employment contract and
give them a bonus for doing so, you must now pay employment
taxes and withhold income taxes on the bonus amount.
Payments made to workers when employment contracts are
canceled must also be treated as wages. Some payments made
before Jan. 12, 2005, will not be subject to these new
rules. •
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4 estate planning strategies
In addition to creating a will and ensuring assets are
titled properly, looking for ways to trim your taxable
estate is an important part of the estate planning process.
Here are four strategies to consider:
- Make gifts to family and friends. Giving to your
loved ones while you’re alive can reduce your taxable
estate. In 2005, you can give up to $11,000 ($22,000 for
married couples) per person without incurring gift tax.
In addition, you can make tax-free gifts under your $1
million lifetime gift tax exemption, but such gifts
reduce the estate tax exemption available at your death.
- Give to charity. Gifts to charity during your
lifetime or at death will reduce your taxable estate.
Lifetime donations may also result in current income tax
benefits.
- Form family partnerships. These are often used to
share business income with children in lower tax
brackets and thereby increase the family’s discretionary
income. Partnerships may also help keep future growth
out of your taxable estate. Keep in mind that the IRS
has scrutinized this strategy, so be sure to study it
carefully before proceeding.
- Create trusts. For individuals, title to assets can
be held in various kinds of trusts. Assets held in trust
for your heirs bypass the probate estate and, depending
on the trust’s structure, may not be included in your
taxable estate. Also, in some circumstances, these
assets may be used to pay estate taxes, debts and
administrative expenses.
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Generating interest with intrafamily loans
Lending money to family members may be personal, but it pays
to treat loans like business. If you don’t, you could owe
taxes on income you never received and gifts you never
intended to make.
Structured properly, however, an intrafamily loan can be a
great way to help your kids or other family members buy a
home, start a business or meet any number of financial
needs. It can also be an effective estate planning tool for
you.
The importance of documentation
Regardless of your loan’s terms, it’s important to put it in
writing. The IRS is likely to view an undocumented loan to a
family member as a gift, which may eat up some of your
lifetime gift tax exemption (currently $1 million) or create
a taxable gift if you’ve already used your lifetime
exemption.
To avoid this result, document the loan with a promissory
note. It should outline the terms of repayment, including
when payments are due, and the interest rate for the loan.
A higher rate’s advantage
It may be tempting to offer your loved ones low-interest or
even no-interest loans, but there can be significant tax
advantages to charging a higher rate. If you lend money to
family members at less than the applicable federal rate (AFR),
the shortfall will be imputed to you.
In other words, you’ll be treated as if you charged the
borrower the AFR and that amount will be included in your
taxable income — whether or not you collect it. What’s more,
this forgone interest will be treated as a taxable gift to
the borrower. The borrower may be able to deduct the
interest, depending on the purpose of the loan.
2 loan options
Two exceptions allow you to make no-interest or low-interest
intrafamily loans without generating imputed interest:
1. The $10,000 exception. You can lend a family member up to
$10,000 without negative tax consequences, provided the
money isn’t invested in income-producing assets. For
example, you could make a $10,000 interest-free loan to your
daughter for a down payment on a condo. But the exception
won’t apply if she puts the money in a savings account.
2. The $100,000 exception. Imputed interest on family loans
up to $100,000 is limited to the borrower’s net investment
income and is eliminated if net investment income is $1,000
or less. Thus, in such situations, there is no taxable gift
for the forgone interest.
Gift calculations
Gifts are calculated differently depending on the type of
loan. If the loan is a term loan, for instance, you can
calculate the gift as the difference between the present
value of the forgone interest for the life of the loan and
the present value of the loan’s stated interest. For a
demand loan, the gift is recalculated annually based on the
forgone interest for that year.
With a demand loan, there is the opportunity to take
advantage of the annual gift tax exclusion each year. (The
annual gift tax exclusion allows you to give up to $11,000
annually to a relative or friend gift-tax free.) On the
other hand, if you exceed your annual gift tax exclusion in
the year of a term loan, you’ll have to use some of your
lifetime gift tax exemption, which is $1 million in 2005.
Estate tax benefits
In addition to helping out your loved ones, an intrafamily
loan can also be a tax-efficient tool for removing wealth
from your estate. Let’s look at an example.
David loans $200,000 to his daughter, Mary, charging 5%
interest (the long-term AFR for the month he made the loan).
Because the interest rate is equal to the AFR, there is no
imputed interest for income or gift tax purposes. The note
provides for payments of interest for 20 years, with the
principal due at the end of the term. Mary invests the money
in mutual funds that yield an 8% annual return.
At the end of the term, the funds have grown to more than
$930,000. Mary pays David the $200,000 principal, which is
included in his estate. But the remaining $730,000 passes to
Mary outside David’s estate, generating substantial tax
savings.
To further assist Mary, David could forgive some or all of
her $10,000 interest payments. Although he would still have
to include the interest in his income, the forgiven payments
would qualify as tax-free gifts under the annual gift tax
exclusion.
Complex rules, costly missteps
Intrafamily loans provide many benefits for both lenders and
borrowers. But the imputed interest rules are complex, and
missteps can be costly. Plan carefully to structure a loan
that meets your needs and avoids unintended consequences.
Taking it to the next generation
Business succession planning
Have you ever wondered what will happen to your family
business after you retire or pass away? Or how you’ll
transition your business to the next generation? Succession
planning issues, like these, are seldom satisfactorily
addressed in a timely fashion. Why?
The simple answer is that business owners often have
conflicting goals. On the one hand, you wish to have a
comfortable income after retirement. On the other, you may
want the business to continue under the leadership of your
children and key employees. However, unless you have
accumulated sufficient retirement savings, the business may
not generate enough income to meet your needs while also
providing adequate financial incentives for your heirs to
run the business.
So how can you deal with these and other conflicts and still
come up with a successful business succession plan? Here are
some suggestions for getting started.
Save for retirement
The business should not be your sole financial security
blanket after retirement. Establishing financial
independence outside of your company will make it much
easier to implement a succession plan.
So start saving as early and tax efficiently as possible by
maximizing annual contributions to a qualified plan, such as
a 401(k), or to an IRA. Even though the eventual
distributions from a qualified plan or traditional IRA are
taxed at ordinary income rates, the tax-deferred growth of
assets inside the plan can be significant over time. Growth
in Roth IRAs will never be taxed, as long as you take only
qualified distributions.
Develop a strong management structure
Another key to successfully transitioning your business is
to train and develop future leadership. Create an
environment in which your children (and possibly other key
employees) are assured that their hard work and time spent
learning how to run the business will be rewarded with
ownership at a clearly defined point in the future.
Invest the time needed to develop a program to train and
develop leadership skills in the next generation.
Determining who will be best suited to hold leadership
positions is also critical. Those you believe hold
leadership potential should be exposed to all aspects of
running the business. The program can be informal or formal
(or both), but it’s essential that a development plan be in
place.
Provide incentives to help retain key employees (whether or
not they are your children) by establishing appropriate
fringe benefit and deferred compensation plans, as well as
incentive pay. Also give them a well-defined path on what
they need to do to become future owners of the business.
Consult with family members
If some of your family members are not currently involved in
the business, you should still encourage the entire family
to participate in the plan, and to understand the financial
and personal consequences of failing to achieve a successful
succession plan.
It’s virtually impossible to successfully transition a
business if nonbusiness family issues aren’t addressed at
the same time.
The most common issue is how to equitably divide assets
among your heirs when only some of them will have control of
or receive ownership interests in the business. If there are
insufficient liquid assets, purchase life insurance to make
adequate provision for children who won’t be involved in the
business. Regardless of how assets are divided, children who
receive other assets may complain that they’ve been denied
the opportunity to share in the future growth and success of
the business; while children who get the business may be
unhappy that they are saddled with an illiquid asset that
requires hard work at substantial financial risk.
One solution is to establish a family trust to own and
operate the business, so that the entire family shares the
risks and benefits.
As you can see, estate planning and business succession
planning go hand-in-hand. You can’t plan for business
succession without considering the effects on your estate
and the impact to your heirs. The tax bite or the emotional
fallout of your actions — or inaction — could doom the
success of the business for the next generation.
Work with professional advisors
There are numerous financial and legal factors to consider
when transitioning your business’s leadership and control.
Depending upon your situation, you may need to involve an
attorney, accountant, insurance advisor, financial advisor
and possibly a family business consultant.
All should work toward four key goals:
1. To establish a management structure that will survive
your departure,
2. To put the business on sound financial footing while
ensuring adequate liquidity to fund your retirement or a
buy-out,
3. To restrict transfers of ownership interests through the
use of a buy-sell agreement, and
4. To minimize income taxes and estate taxes.
Meeting these goals can be a juggling act and may involve
developing a gifting plan; issuing voting and nonvoting
stock; creating preferred equity interests; drafting a cross
purchase, stock redemption or entity purchase agreement;
setting up an installment sale; selling to an employee stock
ownership plan (ESOP); and many other techniques.
Plan now for future transition
Business succession planning is difficult because it’s
impossible to know what conditions will exist in the
marketplace, within your family and for your business at
your retirement or death. The key is to take steps now to
make sure that you and your business are in the best
position to respond to whatever those conditions are and to
ensure a successful business transition.
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Brake for car-related tax breaks
Don’t pass by your opportunity to save
You love to drive them — but do you really understand how
cars can be tax-reduction vehicles? The rules for
car-related deductions are confusing. For example, the
amount you can write off depends not only on operating
costs, but also on how much you use your car and where you
drive. So slow down to understand the rules and avoid
passing by a significant tax-saving opportunity.
What’s deductible
You may deduct expenses for any business use of the car or
if it’s used in connection with an income-producing
activity, such as an investment or rental activity. You
cannot deduct the portion attributable to personal use,
however.
Most of the time, commuting to and from a regular job
doesn’t count as business use. But if your home office is
your primary place of business, or you are going to a
temporary job site or the second business location of the
day, you may escape the commuting label.
To compute your deduction for car expenses, you have two
options: the actual cost method and the mileage rate method.
Actual cost method
Compute the deduction under the actual cost method by
multiplying the total amount of your actual expenses by the
business use percentage. So, if you have $8,000 of expenses
in 2005 for things like lease payments, gas, oil, repairs,
insurance and tires, and you drive the car 80% of the time
for business purposes, you could deduct $6,400 as business
car expenses in 2005.
To claim accelerated depreciation, you must have more than
50% business use. And the “luxury” car rules limit annual
depreciation to an amount specified by the IRS. The term
“luxury” is a misnomer because these limits generally apply
to cars costing only slightly more than $15,000.
For cars purchased in 2005, depreciation is limited under
these rules to $2,960 in this first year. Generally a
Section 179 election is not advisable for cars because of
the depreciation limit.
Mileage rate method
To compute the allowable deduction under the second method —
called the “optional” or “standard” mileage rate method —
you multiply the number of business miles driven by the
standard mileage rate.
For 2005, the mileage rate is 40.5 cents per mile for
business miles. So if you drove 11,000 business miles in
2005, your deduction would be $4,455. The mileage rate is in
lieu of operating and fixed costs, including depreciation,
repairs, tires, gas, oil and insurance. You may, however,
deduct parking fees and tolls in addition to mileage.
Leased cars have even more restrictions. If you use the
mileage rate method, you must use it for the entire lease
period (including renewals).
The standard mileage rate method may not be used in certain
situations, such as when:
- An accelerated depreciation method was used on the
car in any prior year,
- A business is operating a fleet of cars at the same
time, or
- The car is for hire (such as a cab or limousine).
Moreover, if you use the mileage rate method in the first
year of business use, you can use only straight-line
depreciation if you switch to the actual cost method in a
later year. And, before calculating that depreciation, you
must reduce the basis by the depreciation component of the
standard mileage rate, which is 17 cents for miles claimed
for 2005.
More speed bumps
Other rules also conspire to limit your car-related
deductions. For example, employees usually must deduct
unreimbursed automobile expenses as miscellaneous itemized
deductions, which are subject to the 2% limit. Employees who
are reimbursed for automobile expenses by their employers
may or may not see a tax impact on their tax return
depending on the type of business expense reimbursement plan
established by the company.
Determining whether you’re eligible and the amount you can
deduct is complicated and can’t be done at high speed. But
these tax breaks are worth braking for.
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