Tax Tips
Maximize Section 179 election
Under Internal Revenue Code Section 179, you can elect to
expense the cost of certain business property in the year
you buy it rather than recovering the cost over several
years through depreciation deductions. The Jobs and Growth
Tax Relief Reconciliation Act of 2003 boosted the maximum
annual Sec. 179 deduction from $25,000 to $100,000 through
2005, and last year’s American Jobs Creation Act extended
the higher limit (which is annually adjusted for inflation)
through 2007.
Recently, the IRS issued final regulations that give
businesses more flexibility to take advantage of Sec. 179.
For tax years beginning after 2002 and before 2008, you can
make a late Sec. 179 election or revoke a past election on a
timely filed amended federal tax return. Previously, these
changes required the IRS’s consent.
For 2005, the expensing limit is $105,000. But the amount
you can expense is phased out on a dollar-for-dollar basis
when your total investment in Sec. 179 property for the year
exceeds $420,000 (also adjusted annually).
Facsimile signatures permitted
Corporate officers and duly authorized agents can now sign
employment tax forms by facsimile — that is, using rubber
stamps, mechanical devices or computer software programs —
under new rules recently announced by the IRS. The rules
apply to the following forms and their variants:
- Any form in the 940 series,
- Form 1042: Annual Withholding Tax
Return for U.S. Source Income of Foreign Persons,
- Form 8027: Employer’s Annual
Information Return of Tip Income and Allocated Tips, and
- Form CT-1: Employer’s Annual
Railroad Retirement Tax Return.
The regulations are designed to ease
the burden on business taxpayers by simplifying employment
tax filing and reducing the number of returns rejected
because of signature issues.
Watching out for the IRA trap
If you tap your IRA to pay educational expenses, be sure to
read the tax code’s fine print first. Ordinarily, when you
withdraw IRA funds before age 591/2, you’re hit with a 10%
penalty on top of regular taxes. But you can avoid the
penalty if you use the funds for certain purposes, including
paying for qualified higher education expenses. A careful
reading of the tax code, however, reveals the exception
applies only to the extent IRA distributions don’t exceed
your qualified higher education expenses for the taxable
year.
In a recent Tax Court case, a taxpayer learned this the hard
way. The taxpayer used student loans and credit cards to pay
college expenses in 1999 and 2000. In 2001, she withdrew
funds from her IRA to pay off some of the credit card debt.
The court held that the distributions were subject to the
10% penalty because they were used to pay college expenses
incurred in previous taxable years rather than in the
current taxable year.
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Estate planning if you or your spouse isn’t a citizen
Married couples can use a number of tried and true
techniques to shield their wealth from estate and gift
taxes. These include gifts and bequests designed to take
advantage of the unlimited marital deduction, which allows
you to transfer any amount of property to your spouse free
of estate or gift taxes.
There’s a catch: The marital deduction is available only if
the recipient is a U.S. citizen. So if you or your spouse is
a noncitizen, you’ll need to do some extra planning.
Maximize gift tax exclusion and exemption
The most effective solution is for the noncitizen spouse to
become a U.S. citizen. If that’s not possible, the first
solution is to make the most of the gift tax exclusion and
exemption.
You can make tax-free gifts of up to $11,000 per recipient
in 2005. But the limit for gifts to a noncitizen spouse is
$117,000 for 2005; this amount is adjusted annually for
inflation. You can give an additional $1 million tax-free
during your lifetime under the lifetime gift tax exemption,
but this will limit your ability to make lifetime tax-free
gifts to other loved ones. Why? The exemption is not per
recipient, but cumulative.
Create a QDOT
Another option is to establish a qualified domestic trust (QDOT),
which is designed to ensure the assets don’t leave the
United States without being taxed. QDOT assets qualify for
the marital deduction, but they’re eventually subject to tax
in the first spouse’s estate.
To meet QDOT requirements, a trust must be designated as
such on the citizen spouse’s federal estate tax return. It
must also:
- Have at least one trustee who is a U.S. citizen or
domestic corporation,
- Require the trustee to approve all distributions of
principal, and
- Retain sufficient property in the United States to
cover the noncitizen spouse’s estate taxes.
If a QDOT has more than $2 million in assets — or if more
than 35% of its assets consist of real property outside the
United States — it must either appoint a domestic bank as
U.S. trustee or furnish additional security, such as a bond
or letter of credit equal to 65% of its value.
QDOTs have some significant disadvantages. For example, a
noncitizen spouse can’t receive distributions of principal
unless the trustee withholds estate taxes. But assets
remaining in a QDOT when the noncitizen spouse dies are
taxed as if they had been included in the citizen spouse’s
estate — wasting the noncitizen spouse’s exemption.
If the citizen spouse dies without having established a QDOT,
the noncitizen spouse can either become a U.S. citizen or
establish his or her own QDOT to hold the assets before the
due date of the citizen spouse’s federal estate tax return.
Don’t miss opportunities to save
Estate planning is difficult no matter what the
circumstances. But if you or your spouse is a noncitizen,
even more care is needed. Don’t delay or you may miss out on
ways to reduce your estate bill.
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Take care when mixing business with pleasure
How to substantiate entertainment expenses
Entertainment and recreation have always played an important
role in business. And while the IRS and courts pore over tax
deductions for these activities, they also recognize that
business people conduct legitimate business over lunch or on
the golf course.
The scrutiny isn’t surprising. After all, entertainment is
an area that’s ripe for abuse. But if you follow the rules,
you can successfully mix business and pleasure without
giving up the tax benefits.
Supporting your entertainment expenses
Generally, your company can deduct “ordinary and necessary”
business expenses. But the tax code imposes additional
requirements on entertainment expenses.
To support an entertainment expense deduction, you must be
able to show:
- The expense is directly related to or associated
with the active conduct of your business — an expense
may be “associated” with your company if the
entertainment directly precedes or follows a
“substantial and bona fide business discussion,”
- The deduction is adequately substantiated by records
(or other evidence) that establish the amount, time,
place and business purpose of the expense, as well as
the business relationship of the parties involved,
- You had “more than a general expectation” of gaining
a business benefit from the entertainment,
- You engaged in some business activity, other than
the entertainment, such as a meeting, negotiation,
discussion or other bona fide business transaction,
- The “principal character or aspect” of the combined
business and entertainment was business, and
- The expense was attributable to you, your employees
or others involved in conducting business.
Keep in mind, otherwise allowable deductions for meals
and entertainment are generally reduced by 50%. (See the
sidebar “In pursuit of a free lunch.”)
Hunting — and fishing — for tax deductions
In Townsend Industries Inc. v. United States, the Eighth
U.S. Circuit Court of Appeals reversed a district court and
held that the cost of a company’s annual fishing trip was
both deductible as a business expense and excludible from
employee compensation as a working-condition fringe benefit.
Townsend was an Iowa-based manufacturer of printing
equipment. Each summer the company gathered all its
independent sales representatives for a two-day meeting at
its headquarters. Following the meeting, Townsend sponsored
a four-day, expense-paid fishing trip for its sales reps and
factory employees at an upscale Ontario resort. Employees
were encouraged, but not required, to attend. Although
business discussions were conducted on an ongoing basis and
one dinner meeting was held, workers were generally free to
do as they pleased during the trip.
The IRS challenged Townsend’s treatment of the trip
expenses, contending they constituted wages that were
subject to employment and income taxes. The district court
agreed, finding: 1) the “fishing trips were not an ordinary
and necessary business expense in light of the lax
attendance policy for the trip,” 2) there was “a disconnect
between the sales meeting and the fishing trip,” and 3) the
company had no more than a general expectation to derive
uncertain future benefits from the trips.
The court also found Townsend failed to meet substantiation
requirements, citing the company’s lack of contemporaneous,
written records — details on why the expense is business
related — and reliance on employee testimony.
The Eighth Circuit disagreed, ruling that, despite the lack
of contemporaneous records, trial testimony clearly
established the fishing trips had a legitimate business
purpose. Even though the trips were voluntary, employees
“felt an obligation to attend, and some felt it was part of
their job.” Moreover, there was “extensive trial testimony”
regarding specific business issues discussed and problems
solved during the trips.
Learning from Townsend
Townsend is good news for employers, because it confirms the
deductibility of travel and entertainment expenses that
serve legitimate business purposes. But the case also
highlights the importance of substantiating these expenses
with detailed, contemporaneous records. Even though the
employer in Townsend ultimately prevailed without this
information, the litigation cost was great.
Still sitting on the fence?
Picking the best retirement plan for your business
It’s common business knowledge that the key to getting, and
keeping, good employees is to offer a benefit package
they’ll appreciate. But you also want to make sure that you
— as the owner — get all the tax breaks you’re entitled to.
A retirement plan is a good place to start. Whether yours is
a new business just starting out or an existing business now
ready to set up a plan, many of the considerations are the
same.
Not one size fits all
Retirement plans are not a one-size-fits-all proposition.
Most small to midsize businesses implement 401(k) plans,
Savings Incentive Match Plans for Employees (SIMPLEs), and
Simplified Employee Pension (SEP) IRAs for their employees.
Regardless of the plan, employer contributions are
deductible, employee contributions are pretax and plan funds
grow tax-deferred.
To determine which plan is best for your business, you’ll
need to consider a variety of factors. Tax treatment and
contribution limits are obvious concerns. But other factors
also matter: company size and employee limits, employee age
and turnover, employee compensation and company profits,
flexibility of contribution amounts, treatment for owners
and other highly compensated employees, reporting
requirements, and administrative costs.
401(k) plans top the list
401(k)s are by far the most popular form of retirement plan.
They are contributory plans — meaning the employee makes
contributions through redirected salary. You can choose to
match the employee’s contribution, up to certain limits.
401(k)s have a higher employee contribution limit than
either SIMPLE or SEP-IRAs — for 2006, contribution limits
are $15,000, plus $5,000 for the age 50 and over catch-up
amount.
Although the 401(k) has the advantage of higher employee
contribution limits, it also has the most reporting
requirements, making it more costly to create and maintain.
Because annual requirements include filing a tax return
(Form 5500) and compliance testing, most businesses turn
over plan administration to an outside professional.
Employees are always 100% vested in their contributions to
their account. Although amounts redirected to a 401(k)
aren’t currently subject to income tax, the earnings are
subject to FICA and Medicare tax.
You have some flexibility in determining whether to match
your employees’ contributions. Employer contributions can
vest over time, based on plan schedules. If the plan is
top-heavy (favoring highly compensated employees), employer
contribution matching and vesting become subject to IRS
requirements. To maximize your own contributions — as the
owner — you’ll need to monitor and encourage employee
contributions, perhaps by providing an employer match.
SIMPLEs not just a runner-up
There are two types of SIMPLEs: a SIMPLE IRA and a SIMPLE
401(k). Both are contributory plans allowing employee
contributions for 2006 of up to $10,000, indexed for
inflation, and an additional $2,500 for employees age 50 and
older.
With a SIMPLE, you are required to match employee
contributions up to 3% of pay, or you can choose to
contribute 2% of pay for each employee. This matching is
mandatory, unlike with the traditional 401(k). All
contributions vest immediately.
SIMPLEs have a major advantage over 401(k)s in that they
are, in fact, simple. With no annual tax return filing, and
minimal documentation requirements, SIMPLEs are easier to
handle, and you may avoid administration fees altogether.
However, due to their lower contribution limit, SIMPLE plans
may not be a good choice for owners who are seeking to
maximize their retirement plan contributions.
SEP-IRAs funded entirely by employer
Unlike the SIMPLE and 401(k) plans, the SEP-IRA is a
noncontributory plan — meaning no employee contributions are
allowed. The SEP-IRA is entirely funded by employer
contributions. Contributions are discretionary, but cannot
exceed a specified limit — 25% of an eligible employee’s
compensation up to a maximum of $42,000, adjusted for
inflation in 2006. Participants are immediately vested.
SEP-IRAs are easy and inexpensive to set up and administer.
No annual tax return is required, and you have until the due
date of the company tax return (including extensions) to
make your contribution. Although the company must include
all eligible employees, because employer contributions are
optional, contributions can be lower (or skipped) in a year
in which your company is strapped for cash.
A business owner who is self-employed, or employs primarily
family members, may find that a SEP-IRA provides significant
retirement funding benefits. When there are other employees
who must be covered, the employer contribution may be viewed
as too expensive.
You may get a credit for plan startup
If you’re ready to take the plunge and implement a
retirement plan, Uncle Sam may help with some of the costs.
Small employers — those with 100 or fewer employees — may be
eligible for a credit of up to 50% of the first $1,000 spent
on retirement plan administration and education for
employees. This credit is available for the first three
years of the plan — amounting to a maximum of $500 credit
for each year.
We’ve covered only a few retirement plans. Other
possibilities include defined benefit plans and other profit
sharing or defined contribution plans. The greatest benefits
may result from a mix-and-match approach. Combining plans
could increase the allowable contributions for owners. You
may also want to evaluate nonqualified deferred compensation
arrangements to meet your retirement funding goals.
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Private foundations — a plan for family giving
Once considered only for the very wealthy, private
foundations are now being established (and should be
considered) by more “upper-income” individuals. Private
foundations can provide both income tax and estate planning
benefits while enabling you, or your family, to make
meaningful contributions that affect the charities and
causes most dear to your heart.
Another benefit of private foundations is that you can
exercise more control over how your charitable contributions
are used.
Make it a family affair
A private foundation is basically a charitable grant-making
entity that is privately funded and privately controlled.
It’s typically established to manage a long-term charitable
gifting program, with annual distributions to one or more
charities.
A private foundation can serve as a family affair, with your
loved ones participating together to determine which
charities or causes to support and to control the
distributions to charities. In other words, you can create a
family charitable legacy that benefits both the charities
and your family.
Decide which type to establish
Most individuals establish nonoperating foundations in which
a donor, or group of donors, makes contributions to the
foundation and the foundation then makes grants to
charities. The donors and the foundation have no direct
participation in charitable work — they just provide the
funds.
In contrast, an operating foundation may have direct
involvement in charitable work, such as operating a
safe-house for abused women.
Take advantage of income tax deductions
If the private foundation is properly established and
managed, your family will be entitled to income tax
deductions for donations to it. A private foundation can be
particularly useful if you and your family haven’t had a
chance to select the specific charities: You can make your
donation to the foundation, and garner an immediate income
tax deduction. Then, once you’ve made the decision as to
which charities to fund, funds from the foundation can be
distributed appropriately.
The adjusted gross income (AGI) limitations for
deductibility of contributions to nonoperating private
foundations are lower than those for contributions to public
charity 501(c)(3) organizations such as museums, schools and
churches.
Depending on whether cash or property is donated, such
deductions are limited to 20% to 30% of modified AGI per
donor return. (See the sidebar “AGI limitations on
contribution deductions.”)
The amount of a contribution deduction is generally the
property’s basis if ordinary income property is donated and
fair market value for long-term capital gain property. As
with other contributions, unused amounts can be carried
forward for up to five years.
The gift and estate tax deduction is a bit more
straightforward. There are no limitations, and the full
amount of contributions to the foundation is removed from
the donor’s estate. A donor to a private foundation can, in
effect, direct money to charities rather than to the IRS (in
the form of estate tax). At the same time, a family
philanthropic legacy is established that involves multiple
generations and allows all family members to participate in
the decision making. This often satisfies emotional concerns
over distribution of family wealth.
Follow rules regarding control
The increased donor control of a private foundation comes at
a price. You must follow a number of rules designed to
ensure that private foundations serve charitable interests
and not private ones. These rules include requirements for
the
percentage of annual payouts and restrictions on most
transactions between the foundation and its donors or
managers.
Additionally, private foundations are generally prohibited
from benefiting any private individual, with substantial
penalties imposed for failure to meet these requirements.
There are also restrictions on the types of investments that
a private foundation may make, and investment income is
subject to an excise tax of 1% to 2% each year. Finally, a
private foundation is responsible for ensuring that the
funds distributed to a nonpublic charity are properly
expended.
Weigh the costs and plan carefully
Before deciding that a private foundation is right for you,
consider the administrative and legal costs of creating and
managing it. Although a private foundation is tax exempt
(except for any applicable excise tax on investment income),
it’s required to file an annual information return, Form
990-PF. And, the Form 990-PF must be made available for
public inspection upon request. Smaller foundations will
typically need outside help in meeting the compliance
requirements.
The decision to establish a private foundation calls for
advanced planning and consultation with your tax and legal
advisors.
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