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Moore Colson Newsletter -
May/June 2007
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Article 2 | Article 3 |
Article 4
Tax Tips
Take advantage of revitalized tax benefits
Late last year, President Bush signed the Tax Relief and Health
Care Act of 2006. In addition to introducing new rules and tax
breaks, the legislation revives several important tax benefits that
had expired or were about to expire. For example, it:
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Extends the Research tax credit, which had
expired at the end of 2005, to qualifying expenses incurred in
2006 and 2007, and creates new rules for 2007 that will make the
credit more valuable for some organizations,
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Restores the option to deduct sales taxes in
lieu of state income taxes, which had expired at the end of
2005, through 2007,
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Brings back the above-the-line higher education
tuition deduction for 2006 and 2007,
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Renews the Work Opportunity and Welfare-to-Work
credits for 2006 and combines them into a single credit for
2007, and
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Extends several energy incentives, including the
energy-efficient commercial buildings deduction and the
Energy-Efficient Homes credit for contractors, through 2008 —
they had been scheduled to expire at the end of 2007.
As you tax plan for this year and next, be sure to
consider how these changes may affect your or your business’s
financial situation.
No capital gains in certain instances
From 2008 through 2010, the tax rate on certain capital gains and
qualified dividend income will drop from 5% to zero for taxpayers in
the 10% and 15% tax brackets. Assuming that Congress doesn’t
eliminate this favorable rate between now and then, it offers some
interesting planning opportunities. For example, recent retirees may
be able to allocate their assets in a way that puts them into the
15% bracket. By liquidating capital assets to meet their income
needs, it may be possible to shelter the capital gains from taxes.
Parents can also take advantage of favorable capital gains and
dividend rates by making gifts of capital assets to children with
little or no income. To avoid the “kiddie tax” — which applies the
parents’ marginal tax rate to certain unearned income of children
under age 18 — these gifts generally should be made after a child
turns 18. But, if the student is or will be attending college,
consider how the gift may affect his or her financial aid. Also,
watch for potential tax law changes, which may place greater
restrictions on lower capital gains and dividend rates for
dependents under age 24.
Why you should consider a like-kind exchange
Internal Revenue Code Section 1031 allows you to exchange one piece
of real property for another without recognizing any gain, provided
you use both properties in a trade or business or for investment
purposes. A like-kind exchange is one strategy you can use to
diversify real estate investments or relocate a business without
triggering current taxes on the capital gains. The taxes are
deferred until you sell or otherwise dispose of the replacement
property.
To qualify, you must meet a number of requirements, including
identifying replacement property within 45 days after the
relinquished property is sold and completing the exchange within 180
days. A “qualified intermediary” must be used to hold the sale
proceeds and acquire the replacement property.
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How to minimize taxes when giving away your retirement
savings
If your hard work and good fortune enable you to share some
of your wealth with charities, it’s important to consider
the tax implications. After all, the less you pay in taxes,
the more you have left to support the causes you care about.
An effective charitable giving strategy is to donate
tax-deferred retirement plan assets, such as traditional
IRAs or 401(k) accounts. Why? Because retirement plan assets
left directly to charity escape both federal income and
estate taxes. (Keep in mind that not all states follow
federal law.) And recent developments have made it easier
than ever to leverage your retirement savings to make
tax-efficient gifts. Let’s review how you can maximize
retirement plan donations.
Not all assets are created equal
When deciding how to share your wealth — with family
members, charities or others — the type of assets you give
has a lot to do with how much your family ends up sharing
with Uncle Sam. Here’s an example:
Harry has two adult children, Nancy and James. When Harry
dies in 2007, his assets consist of a $600,000 IRA, $600,000
in cash, and $600,000 in stocks, bonds and real estate. With
a total value of $1.8 million, his estate is well within the
$2 million exemption, so federal estate taxes don’t apply.
James is the sole beneficiary of Harry’s IRA. In his will,
Harry leaves the securities and real estate to Nancy and the
cash to several of his favorite charities. Harry believes
he’s treating his children equally, but that assumption is
incorrect when you consider the impact of income taxes.
Nancy receives the full value of the assets Harry leaves
her. Because her tax basis in the assets is “stepped-up” to
their fair market value at the time Harry dies, she could
turn around and sell them tax-free. But James is subject to
ordinary income taxes on Harry’s IRA assets. Assuming that
James takes a lump-sum distribution of the IRA funds, and
that his effective tax rate (including state taxes) is 40%,
his $600,000 inheritance shrinks to $360,000.
Harry could have avoided this result had he named the
charities as beneficiaries of his IRA and left the cash to
James. Harry’s children would have received equal shares of
his wealth and the charities — which are exempt from income
taxes — would have enjoyed the full value of his IRA assets.
This simple adjustment to Harry’s estate plan would have
avoided $240,000 in income taxes.
Limited-time offer for lifetime gifts
Two tax law changes in recent years make it easier — and
less costly — to donate retirement plan assets to charity.
One reduces the tax cost of naming a charity as a
beneficiary of your IRA or qualified retirement plan. The
other, which expires at the end of this year unless Congress
extends it, allows seniors to transfer up to $100,000 in
traditional IRA assets directly to a charity without
triggering any income tax.
Owners of traditional IRAs and, with certain exceptions,
401(k) and other employer-provided retirement plans must
take “required minimum distributions” (RMDs) beginning after
they reach age 701⁄2. So, previously, the only way to make a
lifetime gift of IRA funds would be to take a taxable
distribution from the IRA and then make a gift to charity.
The charitable deduction might offset the income tax on the
IRA withdrawal, but you must itemize and the gift has to be
within applicable income limits. (Generally, you can deduct
cash donations to the extent that they’re less than 50% of
your adjusted gross income.) Depending on your income, some
of the contribution may be lost due to itemized deduction
phaseouts. Additionally, not all states allow itemized
deductions.
The Pension Protection Act of 2006 (PPA) allows you to make
a tax-free qualified charitable distribution (QCD),
regardless of your income level and whether you itemize
(provided the gift is otherwise deductible). As an added
bonus, a QCD counts toward any RMDs in the year it’s made,
generating additional tax savings. To qualify, you must also
meet these requirements:
- Be age 701⁄2 or older when the distribution is made.
- Make the distribution, which must be otherwise
taxable, no later than Dec. 31, 2007, from a traditional
or Roth IRA.
- Make the distribution directly from the IRA to a
qualified charity other than a donor-advised fund or
supporting organization.
Remember that you can’t make QCDs from a SIMPLE IRA,
SEP-IRA, 401(k), 403(b) or other employer-sponsored
retirement plan. But you may be able to take advantage of
the QCD rules by rolling over assets from one of these plans
into an IRA. In most cases, Roth IRAs aren’t appropriate
vehicles for a QCD because distributions generally are
already tax-free.
The gift that gives back
Donating some or all of your retirement savings to charity —
either during your life or at your death — can fulfill your
philanthropic goals while providing valuable tax benefits
for you and your family. Keep in mind that there are several
strategies that can help you meet both objectives, so be
sure to plan and consult your tax advisor.
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Dating games
Backdating stock options can ensnare public — and closely
held — companies
It’s been about a year since the stock option backdating
scandal became almost daily fodder for financial pages
across the United States. Today, well over 100 of the
country’s largest corporations are under investigation for
illegal backdating, and scores of executives and directors
have been forced to resign. Although public companies
continue to grab the headlines, even closely held companies
are getting caught in the backdating trap.
How options work
Despite all the attention backdating has received, the
concept remains widely misunderstood. For various accounting
and tax reasons, most employee stock options are granted “at
the money,” which means their exercise or “strike” price is
equal to the underlying stock’s fair market value (FMV) on
the grant date. So the lower an option’s strike price, the
more valuable the option is to the recipient.
Backdating means selecting a stock option grant date that’s
earlier than the actual grant date to take advantage of
rising stock prices. Let’s say, for example, your company
grants you options to buy 5,000 shares of stock on July 1
when the stock’s FMV is $100 per share. If the company
backdates the options to May 1, when the stock’s FMV was $80
per share and sets an $80 strike price, you enjoy an instant
profit of $100,000, even though the options appear to have
been granted at the money.
Why businesses backdate
To understand why a company would backdate stock options,
you need to know how options are accounted for and taxed,
from a financial statement point of view. Before 2006,
businesses could grant at-the-money stock options without
reporting compensation expenses until the options were
exercised. This enabled them to provide an attractive
benefit to executives with no immediate impact on earnings.
By backdating options, companies could boost an executive’s
profits without taking an earnings hit.
But the accounting rules have changed. Now, employee stock
options must be expensed at fair value. This virtually
eliminates the accounting advantages of backdating.
From a tax perspective, there are distinct advantages to
granting stock options at the money. Generally, options
aren’t taxed until they’re exercised or, in the case of
incentive stock options (ISOs), until the stock is sold.
Under current law, however, “discounted options” — those
with a strike price less than the stock’s FMV on the grant
date — may result in severe tax consequences for the company
and the employee.
How improper backdating can be taxing
Contrary to popular belief, backdating is legal as long as
it’s properly disclosed in the company’s financial
statements, reflected in the company’s earnings and reported
for tax purposes.
Practically speaking, there’s little reason to backdate
options if these conditions are met. In most cases, the
companies implicated in the scandal backdated options for
the very purpose of avoiding these accounting and tax
requirements.
The consequences of improper backdating can be severe. In
addition to significant restatements of earnings, public
companies and their officers and directors risk criminal and
civil liability under federal securities laws. Investors may
bring lawsuits alleging that management improperly enriched
top executives at the expense of shareholders.
Stock options are most common in public companies, but many
closely held businesses also offer them as an incentive to
executives and other employees. Private companies generally
are not subject to the federal securities laws, but they can
still be ensnared in the backdating trap. Substantial
earnings restatements may upset investors, lenders and other
creditors or cause the company to violate loan covenants.
And shareholders may sue officers or directors, alleging
that they breached their fiduciary duties by backdating
options without proper disclosure. In some cases, companies
that conceal backdating on their financial statements may be
accused of fraud.
Improper backdating can also have serious tax consequences.
Options deemed to be granted at less than FMV can trigger
taxes, penalty and interest for the company and its
executives, not to mention disqualifying ISOs.
In addition, backdating can affect the deductibility of
executive compensation. Currently, there’s a $1 million cap
on deductible compensation paid to top executives of
publicly held companies for federal tax purposes. There’s an
exception for “performance-based” compensation, which
includes stock options granted at FMV. If backdated options
are recharacterized as discounted options subject to the
cap, the IRS may deny earlier deductions and assess back
taxes, penalties and interest.
Why you need to take stock of your options
If your company grants stock options to employees, it’s
important to review your program to ensure you’re not guilty
of improper backdating — either intentional or inadvertent.
To avoid even the appearance of impropriety, be sure your
stock option policies and practices are consistent and
properly documented.
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3 tax-wise strategies for sharing your wealth
Is your net worth large enough that estate and gift taxes
are a concern? If so, there are several estate planning
techniques that allow you to minimize taxes and preserve
more of your wealth for your loved ones. Here are three
strategies.
1. Irrevocable life insurance trust
If you own your life insurance policy, the proceeds will be
included in your estate and nearly half of its value may be
lost to estate taxes. You can avoid that scenario by setting
up an irrevocable life insurance trust (ILIT) to buy and
hold the policy. This allows the proceeds to bypass your
estate and go to your loved ones tax-free.
For an ILIT to work, it must be designed carefully. To keep
the insurance proceeds out of your estate, you can’t retain
any “incidents of ownership” in the policy, such as the
right to change beneficiaries or the right to cancel,
surrender, pledge or borrow against the policy.
And, if possible, the trust should buy the policy. Although
you can transfer an existing policy to an ILIT, the proceeds
will be included in your estate if you possess any incidents
of ownership within three years before you die.
The funds you contribute to the trust to pay insurance
premiums and other expenses are taxable gifts to your
beneficiaries. But you can avoid gift tax by using your
lifetime gift tax exemption (currently, $1 million) or your
annual gift tax exclusion ($12,000 per recipient in 2007).
To qualify for the annual exclusion, however, contributions
must be considered “completed gifts,” which means that your
beneficiaries must be given the right to withdraw the funds
for a limited time (usually 30 days).
2. Qualified personal residence trust
If you’d like to continue living in your home while reducing
your estate, consider a qualified personal residence trust (QPRT).
It allows you to transfer your principal residence or
vacation home to your children or other beneficiaries at a
reduced tax cost — all while retaining the right to live in
the home for a specified term.
When you transfer a home to a QPRT, any future appreciation
of the home is sheltered from estate tax. And the value of
your initial gift for gift tax purposes is based on your
beneficiaries’ remainder interest in the home, which is only
a fraction of its current value.
It’s important to select the trust term carefully because
the longer the term, the lower the value of the remainder
interest. But a QPRT is effective only if you survive the
term. Keep in mind that, after the trust expires, your home
is owned by the trust or, if the terms call for it to be
distributed, the trust beneficiary or beneficiaries. Of
course, you can continue living in the home — as long as you
pay fair-market rent to the owner.
Special considerations apply if the home is subject to a
mortgage or if your beneficiaries are grandchildren or
others, which might raise generation-skipping transfer (GST)
tax issues.
3. Charitable remainder trust
If philanthropy is one of your estate planning objectives, a
charitable remainder trust (CRT) can help you achieve that
goal while providing current tax benefits for you and your
family. To take advantage of this technique, transfer assets
to an irrevocable trust that pays income to you or your
beneficiaries for life or a specified term and then
distributes the remaining assets to a qualified charity.
A CRT is ideal for converting highly appreciated assets into
a current income stream. Suppose you own real estate that
has appreciated significantly in value. You’d like to sell
the property and put the proceeds into income-producing
investments, but you’d have to pay taxes on the capital
gains.
If, instead, you contribute the property to a CRT, which is
a tax-exempt entity, the trustee can sell the property
tax-free and reinvest in a diversified portfolio. You defer
— and potentially avoid — capital gains taxes and enjoy a
regular stream of income (subject to income taxes, of
course). You’re also entitled to a current income tax
deduction for the value of the charity’s remainder interest.
Keeping it in the family
ILITs, QPRTs and CRTs are just a few of the techniques you
can use to share your wealth with your family at a lower tax
cost. Finding the right strategy for you will depend on your
specific financial situation and estate planning goals.
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