Moore Colson :: News & Resource Center

Tax Tips

Catching up on depreciation

Determining the appropriate depreciation methods and periods for fixed assets can be complicated. So it’s not uncommon for assets to be misclassified from time to time, especially in a capital-intensive business.

This can happen for any number of reasons. Perhaps you mistakenly classified a three-year asset as a seven-year asset or maybe you overlooked opportunities to claim a first-year depreciation bonus for property placed in service between 2001 and 2004.

A good way to give your cash flow a boost is to review your depreciation schedules periodically to identify assets that could have been depreciated more quickly. You may be able to take a catch-up deduction this year based on the difference between the depreciation deductions you were entitled to claim on those assets and the deductions you actually claimed.

Are you prepared for disability?

A good health insurance policy pays for the medical care you need in the event you’re injured or become ill. But it does nothing to replace your lost income if you become disabled and are unable to work. One way to protect yourself is to obtain a long-term disability policy.

Some employers offer disability coverage as an employee benefit, but group coverage may not be as extensive as an individual policy. Plus, if your employer pays the premiums and doesn’t include the cost in your income, any benefits you collect will be taxable. If you pay the premiums yourself with after-tax dollars, the benefits will be tax-free.

“Campaign” reform

The Pension Protection Act of 2006 tightened substantiation requirements for charitable gifts. Gifts less than $250 require a bank record or written acknowledgment from the donee showing the donee’s name, and the amount and date of the contribution. Larger gifts require a written acknowledgment from the donee containing the above information as well as a statement regarding the nature and value of goods or services, if any, that were provided to the donor in return for the contribution. Some types of gifts require additional substantiation.

Gifts to a Combined Federal Campaign or United Way campaign often flow through to other charities, so there was some confusion over which donee or donees were required to provide the acknowledgment. In a January 2008 notice, the IRS made it clear that a written acknowledgment from the campaign organization satisfies substantiation requirements, provided it lists the ultimate recipients of the gift.

Estate planning for noncitizens

If you or your spouse is a noncitizen, be sure to adjust your estate plan accordingly. Gifts to noncitizens don’t qualify for the unlimited marital deduction. That deduction allows individuals to transfer any amount of property to their spouses free of gift and estate taxes. To leverage the benefits of the marital deduction, many married couples’ estate plans take advantage of marital trusts.

Fortunately, there are other tools noncitizen married couples can use, such as a qualified domestic trust (QDOT). By incorporating certain protections that ensure the trust assets will stay in the United States and eventually be subject to estate taxes, a QDOT allows noncitizen couples to take advantage of the marital deduction.

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Private foundations
Retain control over your donated funds — for a price

It used to be that the cost of setting up and operating a private foundation was justified only if you planned to contribute several million dollars. But that cost has dropped dramatically over the years, so this strategy may be worth a look for donors making initial contributions as low as $250,000. Of course, whether a private foundation is right for you depends on your circumstances.

Hands-on philanthropy

There’s really only one reason to establish a private foundation: Control. If you’re not interested in directing the manner in which your donations are spent, there are easier and cheaper ways to give to charity. But if you prefer a hands-on approach to philanthropy, a foundation can be a powerful tool.

A private foundation is a tax-exempt entity typically structured as a not-for-profit corporation that you establish to accept charitable contributions. The foundation’s board of directors — which may include you, family members, friends and trusted advisors — manages the foundation’s assets and directs grants to other charities. So if you become dissatisfied with an organization’s performance or your charitable philosophies or goals change, you can redirect the foundation’s assets elsewhere.

A private foundation also offers many of the same benefits as other charitable giving vehicles, such as those discussed in “Alternatives to private foundations” on page 6. For example, it allows you to make a large contribution — and receive a large charitable deduction — in one year while distributions to the charities themselves can be spread over a period of years. It also provides a way to highlight your philanthropy in your community as well as establish a legacy of family giving.

Drawbacks and pitfalls

A private foundation is a highly regulated entity that must be planned and operated carefully. Here are some areas to consider:

The cost. Setting up a foundation typically costs between $5,000 and $10,000. Annual administrative costs depend on several factors, including the size of the foundation and whether you plan to hire staff to operate it. According to the Council on Foundations, a typical $1 million foundation has an annual charitable budget (grants plus expenses) of 5.5% of assets, or $55,000, and annual administrative costs of 15% of the charitable budget, or $8,250.

Lower tax deduction limits. Generally, you can deduct cash contributions to a nonoperating foundation (the most common type) up to only 30% of your adjusted gross income (AGI), compared to 50% for cash donations to other types of charitable vehicles. For noncash contributions, the limit is typically 20% of AGI, compared to 30% for those to other vehicles.

Excise taxes. Private foundations, though tax-exempt, are subject to excise taxes of 1% to 2% on their net investment income. Also, foundations that fail to make qualified distributions of at least 5% of their net assets each year must pay a 15% excise tax on the shortfall. Qualified distributions include grants to public charities and reasonable administrative expenses.

Corporate governance and self-dealing. A private foundation’s directors have a fiduciary duty to the foundation. They risk civil and criminal penalties if they fail to exercise reasonable care in overseeing the foundation’s activities and officers, or fail to act in the foundation’s best interests. Perhaps the biggest risk for private foundations is the prohibition against self-dealing. It forbids transactions between a foundation and “disqualified persons,” such as:

The founder and members of his or her family,
Officers, directors and certain employees,
Significant donors, and
Certain related entities.

A violation can result in significant penalties and even the loss of the foundation’s tax-exempt status.

The self-dealing rule is particularly dangerous because a person can violate it even if he or she has the foundation’s best interests at heart. For example, a director who sells an office building to the foundation is considered to be engaged in self-dealing even if the purchase price is well below the property’s fair market value.

Lack of privacy. Despite its name, a private foundation isn’t the right vehicle if you want to keep your charitable activities private. Private foundations are required to file Form 990-PF each year with the IRS and make it available for public inspection.

Building a strong foundation

Private foundations offer a powerful combination of tax advantages and management control. With some due diligence and tax and legal advice, a foundation may be the right vehicle for achieving your philanthropic goals.

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Are your compensation arrangements in compliance?

Late last year, the IRS gave companies a reprieve until Jan. 1, 2009, to bring nonqualified deferred compensation arrangements and documents into compliance.

The extension is welcome news for many companies that were wrestling with complex final regulations under Internal Revenue Code Section 409A. But that doesn’t mean you don’t have to comply with the regulations yet, because “good-faith” compliance with Sec. 409A itself and related IRS guidelines has been required since 2005. Of course, the best way to demonstrate good faith is to continue your compliance efforts.

Sec. 409A requirements

Lawmakers passed Sec. 409A in the wake of the corporate scandals such as Enron. The provision is intended to prohibit deferred compensation arrangements that allow executives or other employees to defer income taxes while retaining an inappropriate level of control over the timing of the benefits.

These requirements apply to a variety of nonqualified deferred compensation arrangements, including bonus plans, supplemental executive retirement plans (SERPs) and certain severance pay plans. They also apply to discounted stock options and stock appreciation rights (SARs) — that is, options or SARs that are issued at less than fair market value.

The rules don’t apply to qualified retirement plans — such as 401(k) plans — or to certain short-term deferrals (for example, a year end bonus paid within 21⁄2 months after the end of the tax year). Also excluded are most welfare benefit plans, such as vacation, sick leave, compensatory time, disability and death benefit plans.

Applications

In general, Sec. 409A and the final regulations impose strict requirements on the timing of deferral elections and an employee’s ability to alter the form or timing of the payments. Here are three examples:

1. Employees must make the initial deferral election before the year in which they perform the services for which the compensation is earned. So, for instance, an So, for instance, an employee who wishes to defer part of his or her 2009 compensation to 2010 or beyond must make the election by the end of 2008. There are exceptions for new employees and certain performance-based compensation.

2. Benefits must be paid on a specified date, according to a fixed payment schedule or after the occurrence of a specified event — such as death, disability, separation from service, change in ownership or control of the employer, or an unforeseeable emergency.

3. The timing of benefits can be delayed, but not accelerated. Elections to change the timing or form of a payment must be made at least 12 months in advance. Also, new payment dates must be at least five years after the date the payment would otherwise have been made.

Penalties for noncompliance are harsh: They include immediate taxation of any vested benefits plus a 20% excise tax and interest.

In extending the compliance deadline through 2008, the IRS also extended a transitional rule that gives employers additional flexibility to change the timing or form of deferred compensation payments to correct compliance issues. The transitional rule can’t be used, however, to delay payments that otherwise would have been made this year or to accelerate payments due in later years into this year.

Taking stock of your options

Sec. 409A presents a problem for “stock rights,” such as stock options and SARs: Requiring employees to decide in advance when they’ll exercise such a right defeats the purpose of these benefits, which is to give employees some flexibility on when they cash out. So Sec. 409A makes an exception for certain stock rights — those issued at fair market value. The best way for a private business to accomplish this is to have its stock valued periodically by a qualified, independent appraiser.

To avoid potentially disastrous tax consequences, review any existing stock rights and take remedial action, if needed, before the end of 2008. The transitional rule allows you to bring stock rights into compliance by substituting a nondiscounted right for a discounted one or establishing a fixed exercise date. Special rules apply to employees who have previously exercised discounted stock rights.

It’s critical to correct noncompliant stock rights before year end. If you don’t, stock rights that are vested on or after Jan. 1, 2009, will trigger taxes and penalties whether employees exercise them or not.

Professional help

Sec. 409A and the final regulations are exceedingly complex and the consequences of noncompliance can be severe. If your business provides deferred compensation to employees, or has done so in the past, consult your tax advisor now to determine whether Sec. 409A applies to you and, if so, what steps you need to take this year.

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Vacation homes provide tax planning opportunities, pitfalls

If you own a vacation home, it pays to consider the income tax implications, especially if you plan to use the home for both personal enjoyment and rental income. In some cases, minor adjustments in the way you use the home can reduce your tax bill.

Residence or rental classification

The income tax treatment of a vacation home depends in part on whether it’s classified as a residence or as a rental property. A vacation home is considered a residence if your personal use of the home during a given year exceeds 14 days or 10% of the number of rental days, whichever is greater. So, for example, if you rented out your vacation home for 90 days during the year, your personal use would have to exceed 14 days, because that’s greater than 10% of the rental days. But if you rented it out for 180 days, your personal use would have to exceed 18 days.

This sounds like a simple test, but distinguishing between personal and rental use can be tricky. Personal use includes use by you, your family (including your spouse, siblings, parents, children, grandchildren or other lineal descendants), a co-owner, someone with whom you’ve done a home exchange, or anyone else who doesn’t pay fair market rent.

Use by family members is considered personal even if they pay fair market rent (unless the home is their primary residence). But days that you spend substantially full-time on repairs and maintenance aren’t considered personal use.

Tax considerations

When a vacation home is classified as a residence, the number of rental days affects the tax treatment:

If you rent out the home for less than 15 days a year, the rental income is tax-free. But you won’t be able to deduct any rental expenses. Nevertheless, the tax-free treatment can be a valuable tax break, especially if an important event is held nearby and market rental rates are at a premium.
If you rent out the home for 15 days or more, you’ll have to report the revenue as income. But you also may be entitled to deduct some or all of your rental expenses.

Regardless of the home’s classification, you have to allocate interest, taxes and other expenses (such as utilities, repairs, maintenance, insurance and depreciation) between personal and rental use. But the home’s classification will affect the deductibility of these expenses:

Residence. You can deduct the personal portion of mortgage interest and property taxes as itemized deductions. Generally, you can deduct interest on up to $1 million in acquisition debt on your main residence and a second residence. But note that property taxes aren’t deductible for alternative minimum tax (AMT) purposes, so you could lose that deduction if you’re subject to the AMT.

The rental portion of expenses (assuming you rent the home for 15 days or more) is deductible up to the amount of rental income. In other words, if rental expenses exceed rental income, you can’t deduct the loss from your salary or other income. But you can carry it forward to offset rental income in future tax years.

Rental property. The personal portion of mortgage interest isn’t deductible, but the personal portion of property taxes can be reported as an itemized deduction. Rental expenses are deductible, and you can deduct losses, subject to the passive loss rules.

Passive losses generally are deductible only against income from other passive activities. But, the rules may allow you to deduct up to $25,000 in rental losses, provided you “actively participate” in the property’s management. This deductibility is phased out beginning when the owner’s modified adjusted gross income (MAGI) is $100,000 and eliminated when it reaches $150,000.

You can deduct unlimited losses if you’re a “real estate professional,” which generally means you have more than 750 hours of work activity related to real estate or spend more than 50% of work time in real estate. But vacation homeowners typically aren’t able to meet this test.

Determining the lowest tax bite

Cindy, whose MAGI is $100,000, owns a lakeside vacation home. During the year she uses it 20 days and rents to vacationers 80 days, collecting a total of $16,000. Her mortgage interest is $14,000, her property taxes are $6,000, and her other expenses total $8,000 for the year.

Because the home is considered a residence, Cindy’s rental expense deductions are limited to her $16,000 in rental income. Based on her use of the home, her expenses are 20% personal and 80% rental, so she can deduct 20% of her interest and taxes, or $4,000, as itemized deductions. The remaining $16,000 of interest and property tax expenses can offset her rental income, but she can’t deduct any of her other expenses. She could carry the rental loss of $6,400 (80% of $8,000) forward to offset rental income in future years, but she might never have enough rental income to absorb it. So, her total deductions related to the home are $20,000 for the year.

If Cindy reduces her personal use to 14 days, the home becomes classified as a rental property, and her expenses are now approximately 15% personal and 85% rental. The rental portion of interest, taxes and other expenses is $23,800 (85% of $28,000), resulting in a $7,800 loss, which is fully deductible because it doesn’t exceed $25,000. Although Cindy can’t deduct the personal portion of interest, she can deduct the 15% personal portion of her property taxes, or $900, as an itemized deduction. By converting the property from personal to rental, she increases her total deductions related to the home to $24,700.

But if Cindy’s MAGI were $150,000, the $7,800 loss couldn’t be deducted currently and instead would be carried forward until the property was sold or had a profit. In that case, Cindy’s deductions would be higher if the home were treated as a residence.

Note that, if Cindy were subject to the AMT, the results also would be different because of the loss of the deduction for the personal portion of property taxes. They also could be different if she had other passive income she could offset with the rental loss.

Do the math before you relax

Owning a vacation home can bring much personal enjoyment as you, your family and perhaps future generations create new memories of time spent together. But it can also complicate your tax situation, particularly if you rent out the home. By understanding the tax implications of your buying a vacation home, you’ll be able to reduce your tax bite and better enjoy the time you spend there.

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