Tax Beat

November 2008 | Download

In 2008, we saw two major pieces of tax legislation signed into law, the newest being The Emergency Economic Stabilization Act which was signed into law in October. Although the legislative centerpiece was not tax law, many important tax law changes came out of this legislation (see page 6 for a summary). Along with these two pieces of tax legislation, many are wondering what possible tax law changes may emerge from a new presidential administration.

While changes are historically made early in a new administration, we are uncertain what, if anything, will happen, and when the change will be enacted. Many factors may change between now and Inauguration Day that could affect plans or campaign promises. We will keep you informed of any changes, but if you have questions about proposed or scheduled tax changes, please contact us.

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SAVING MONEY FOR COLLEGE

According to the College Board, the average college costs for tuition, fees, and room & board were $13,589 at in-state public schools and $32,307 for private institutions last year. This represents a 6% increase from the year before, and college costs are expected to continue climbing. Even a student who lives at home and keeps expenses to a minimum will have to pay an average of $6,185 just for basic tuition and fees at a 4-year college.

Though the costs of higher education may be frightening, you can act now to help soften the blow of future college costs. Proper planning is the key to paying for college. The worst approach is to do nothing and hope for the best later. While you might win the lottery or raise a scholarship athlete, it is far more likely that you will bear some of the burden of your child’s future education. The days are long gone for student working through college with summer jobs.

In fact, that summer job may not be the best financial tool to save for college. For financial aid purposes, there is a standard formula to determine a family’s expected contribution toward college expenses (the Expected Family Contribution, EFC). Though it is a complicated formula to determine what constitutes family assets, for discussion purposes the bottom line is that 20% of the student’s assets and 5.6% of the parents’ assets are counted against the amount of financial aid available to the student (see the November 2005 issue of the Tax Beat, located on our websi te www.komisarbrady.com for a discussion on college financial aid planning). Therefore, it is often wise to utilize parentdirected college savings accounts rather than those owned by the student. Consider some of the following options:

529 Plans
The best option for most families to save for college is a 529 plan. Named after the Internal Revenue Code section that created them, 529 plans allow tax-free growth on investments and tax-free withdrawal (when used for tuition, room and board, or books). Section 529 plans generally offer a limited selection of investment choices from which to choose, and initial contributions to open the plan can be as low as $25 (Wisconsin’s EdVest plan has an initial investment requirement of $250 to open an account, which is waived if an automatic investment plan is started). A plan can be funded by a parent, grandparent, friend – anyone. If the beneficiary doesn’t use the money, you can transfer the assets to another family member. Additionally, the assets in the 529 account in the parents’ names are considered assets of the parents, not the student, for the purposes of determining financial aid. Better yet, when a grandparent sets up a 529 account, it is not considered an asset for the purposes of determining a student’s financial aid!

For a high-income taxpayer, the 529 plan is an attractive option to make contributions because of the high contribution limit and no income limitation. For the Wisconsin plan, the maximum total contribution is $330,000. Furthermore, a person can make a gift of up to $12,000 each year ($24,000 per couple) without triggering gift taxes. The IRS also allows a person to make up to five years’ worth of gifts at one time, meaning that a person can make a one-time $60,000 gift without paying gift taxes (assuming they do not make further gifts to that child in the next 5 years). A gift tax return though will need to be filed.

Wisconsin residents (parents, grandparents, aunts, and uncles) who contribute to the Wisconsin plan, called Edvest, will reduce their taxable income by their Edvest contributions, up to $3,000 per child.Since Wisconsin’s tax rate is approximately 6%, that represents an additional savings of $180 per year. However, you are not limited to investing in your own state’s plan. Though you may lose the Wisconsin tax deduction by using another state’s plan, other plans may have lower fees or other investment choices. You can compare plans at collegesavings.org.

The 529 plans do have a few drawbacks. They generally offer only a handful of investment choices, most of which are designed for steady growth rather than spectacular performance (or the risk required for that potentially spectacular performance). The plans are designed for simplicity and stability more than flexibility. You may also consider a different savings vehicle if you think that you may need the money for something beside education. Withdrawals from a 529 plan that are not used for college require you to pay taxes on the earnings portion of the withdrawal, along with a 10% penalty assessed on the taxable amount. Any tax benefits sought by using a 529 plan are essentially lost if the money is used for anything other than qualified college expenses. Investors should also know that 529 plans can be funded either directly or through an investment advisor. The investment choices are identical; the only difference is often that plans funded through an advisor have an additional 1-2% fee.

Coverdell Accounts

Coverdell Educational Savings Accounts (formerly known as educational IRAs) also offer tax-free savings in order to save for college. The positive side is that the investment options are virtually unlimited. A good investment advisor can often find investment choices that are superior to the limited offerings in a 529 plan. Earnings and withdrawals for educational purposes are tax-free just like a 529 plan. Withdrawals from a Coverdell account are allowed to be spent on a wider range of educational expenses than a 529 plan, including primary or secondary education expenses.

The primary drawbacks to a Coverdell account are the contribution limits. The Coverdell can only be funded by families who fall under the income limits (an AGI less than $220,000 for a married couple). Contributions are limited to $2,000 per year, which will fall to $500 in 2010 unless Congress acts. Higher income families are ineligible to have a Coverdell account, and even those who have it are not allowed to contribute very much to the account. A Coverdell is often a good supplement to a 529 plan, but rarely is enough to completely pay for college. Like 529 plans, any withdrawals not used for educational purposes will be subject the earnings portion of the withdrawal to tax, along with a 10% penalty assessed on the taxable amount.

Custodial Accounts

Many parents choose to save for the child’s education with a custodial account, often called an UGMA or UTMA account. The positive side of such accounts is that they can be used for any purpose, not just college expenses. Custodial accounts are good savings choices if you are unsure whether or not your child may attend college. They also have a nearly unlimited selection of investment choices, meaning that a talented investor can often find more profitable investments and lower fees than may be available through a 529 plan. Though not as tax-advantaged as a 529 plan or Cover-dell account, the first $850 in annual investment earnings in an UGMA or UTMA are tax-free, and the next $850 in earnings are taxed at the child’s rate.

The downside of custodial accounts is that earnings above $1,700 are taxed at the parents’ tax rate, a phenomenon known as the “kiddie tax.” Additionally, as custodial accounts, they are owned by the parent until the child reaches age 18 for an UGMA account and age 21 for an UTMA account, at which time ownership shifts to the child. Once the child is the owner of the account, he or she can spend it on whatever they like – which may not include college. Custodial accounts can also negatively affect one’s financial aid package, since they are considered part of the student’s assets.

Prepaid Tuition

Some schools offer prepaid tuition plans. Most often used by families who know that a child is going to attend the alma mater of an alumnus, prepaid tuition plans offer the opportunity to pay tuition in advance at reduced rates. If you know that Junior is going to attend Notre Dame when he is older, you can pay for future tuition at today’s prices. The upside of a prepaid tuition plan is the cost savings by prepaying the tuition. Often you are paying today’s prices for what is likely to be much more expensive in the future. There may even be a discount by prepaying. The downside, of course, is if the child does not attend the chosen institution. Most plans refund at least the initial investment with perhaps one or 2 percent annual return, but that is generally a poor return on investment. Additionally, there are only a few schools that offer prepaid tuition plans. There is also an independent prepaid tuition plan called Independent 529 that allows you to prepay tuition that can be used at any of its hundreds of member colleges (for a complete list, see independent529plan.org). Wisconsin member schools are Concordia, Ripon, Lawrence, and Lakeland.

Determining how to pay for a child to attend college can be daunting, no matter what age your children are. We would be happy to provide assistance or direction.

As the housing market has experienced a slow-down, the Housing Assistance Tax Act of 2008 was passed in order to stimulate the housing market, and included an important but confusing new tax credit. The First-Time Home Buyer Credit offers a refundable tax credit of up to $7,500 for taxpayers who meet the following criteria:

• have not owned a home in the past three years
  
• closed on a home between April 9, 2008 and July 9, 2009
  
• the home will serve as their principal residence
  
• it was not purchased from a close relative
  

The refundable credit can reduce your tax liability to zero, and you can receive a refund of the difference. If two or more unmarried taxpayers purchase a home together, their aggregate credit cannot exceed $7,500. Though the credit begins to phase out for people with adjusted gross income (AGI) of $75,000 ($150,000 if married filing jointly), thousands of people are expected to be eligible for the credit.

However, the credit must be repaid, and thus it should really be considered an interest-free loan that must be paid back over a 15-year period. Beginning two years after the credit is claimed, the taxpayer must repay the credit for the next 15 years. For example, a taxpayer buys her first home and claims a $7,500 credit in 2008. Beginning in 2010, and for the next 15 years, the taxpayer then files a tax return that includes repayment of the credit of $500 ($7,500 divided by 15 years). The IRS has described a few different situations in which the credit will not need to be ratably repaid over the 15 years, including:

• Death: Any remaining installments will not be due if the taxpayer dies before making the final installment. However, if the taxpayer files a joint return, the surviving spouse would be required to repay his or her half of the remaining repayments.
  
• Change in use: If the taxpayer ceases using the home as its principal residence and uses it as a vacation home or rental property, all remaining installments become due on the return for the year in which the change occurs.
• Sale: If the taxpayer sells his home, all remaining annual installments become due on the return for the year of sale, limited to the gain on the sale of the home. If there is no gain on the sale, or sold at a loss, the remaining annual repayments may be reduced or even eliminated.
  
• Transfer: If the taxpayer transfers the home to a spouse, or as part of a divorce settlement to a former spouse, the transferee is responsible for making all subsequent installment payments.

The good news is that you may be able to get a loan at 0% interest – a much better rate than any bank will offer. A possible disadvantage is that taxpayers may be tempted to view the $7,500 as a gift and may be surprised when their tax bill increases up to $500 in subsequent years.

STOCK MARKET DOWN? YOUR MUTUAL FUND MAY STILL HAVE CAPITAL GAINS DISTRIBUTIONS

With most domestic and foreign mutual funds declining this year, you might think that there would be little to no capital gains for the mutual funds to distribute to its investors this year. According to an October 22nd article in the Wall Street Journal, some investors may have to pay a hefty tax bill on their losing mutual funds.

When a mutual fund sells a security it holds, it has a capital gain or loss. The net of all the capital gains or losses are distributed to the its shareholders if there is a net gain. If the mutual fund sold securities at a gain prior to the market decline and has not sold any securities as they have declined, the mutual fund may have capital gains to distribute. These capital gains are typically distributed to investors around the end of the year, and the distributions are taxable if held in a taxable account and not a retirement account.

Since capital gain distributions in taxable accounts create current year taxable income without increasing the value of your investment, it may be a good time to consider selling some underperforming funds before they create taxable distributions. It also means that if you are going to invest in a mutual fund, you need to be aware of the distribution date and avoid purchasing them until after that date.

Most funds publish the date that capital gain distributions will be made. Some funds have already published preliminary payout estimates that can be used to calculate income tax owed if a fund is owned on the distribution date. A word of caution to you if you decide to sell a mutual fund: If you sell a fund at a loss and decide to reinvest the proceeds, the “wash sale” rule may prevent you from recognizing that loss at this time. The wash sale rules state that you cannot deduct losses from the sales of stock or other securities and buy the same or “substantially identical” securities 30 days before or after the sale. Two different companies’ “Midcap Growth and Income Funds” may be considered “substantially identical” funds.

If you have additional questions about this or any other topic, or need assistance in calculating the taxable implications of a capital gain distribution, please give us a call.

SUBSTANTIATION OF CHARITABLE DEDUCTIONS

The IRS continues to tighten requirements for substantiating charitable donations. The Tax Court recently held that a couple could not deduct donations to their church because they had not received “contemporaneous substantiation” of their donation (Gomez, TC Summary Opinion 2008-93). In 2005, Mr. and Mrs. Gomez donated $6,500 in 20 separate checks. They produced cancelled checks upon audit, but because most donations were more than $250 each, the IRS required an acknowledgment letter from the church. The couple procured a letter from their church dated January 22, 2008 confirming the amounts received. The IRS still denied the contributions, because the letter was not received at the time Mr. and Mrs. Gomez filed their return. In their words, the substantiation was not contemporaneous to the deduction. The IRS did not dispute that the church was a qualified charity and that the payments were made as claimed. The denial of the deduction was solely due to the timing of the written acknowledgement. The Tax Court did allow the deduction of eight of the checks that were below the $250 threshold for the written acknowledgement requirement, but disallowed the majority of the deduction.

Code Section 170(f)(A) requires the taxpayer to receive contemporaneous written acknowledgement for contributions of $250 or more. A written acknowledgement is only contemporaneous if it is received by the earlier of the date of filing or the due date of the return, including extensions. The donor bears the responsibility for requesting and obtaining the written acknowledgement. Before claiming a charitable deduction of over $250, be sure to obtain written acknowledgment of the gift, including the date and amount of the gift, and whether or not goods and services were received in consideration of the gift (and, if so, a good faith estimate of their value). If you are part of a charitable organization, be sure you have procedures in place to provide prompt confirmation of donations.

FDIC LIMITS INCREASED FOR THE FIRST TIME IN OVER 25

With the current declines in the stock market, the lingering mortgage crisis, and bank failures, people are justifiably concerned about the safety of their money. To combat the issue, Congress passed the Emergency Economic Stabilization Act of 2008 which temporarily increases the deposit insurance limits. These changes impact the amount of coverage for single ownership bank accounts, but do not affect IRA or brokerage accounts.

The new deposit insurance limit covered by the FDIC (Federal Deposit Insurance Corporation) for single ownership accounts is $250,000. Savings, checking, certificate of deposits (CDs), and money market deposit accounts are all considered single ownership accounts and covered by the increased limit. All single ownership accounts owned by the same person at the same bank are added together and the total is insured, up to $250,000. The limit does not change for having different accounts at other branch locations of the same bank. Each separate bank insures these accounts up to $250,000. Therefore, it is advantageous to create accounts at separate banks. Money invested in stocks, bonds, mutual funds, life insurance policies, annuities, or municipal securities are not covered, even if they are bought from an insured bank. Joint accounts allow owners to split their share of an account with other people, and only that person’s share goes towards the individual’s $250,000 total. Revocable trust accounts are treated as a separate owner from an individual account. The increased insurance coverage stays in effect until December 31, 2009, when it goes back to the usual $100,000.

IRA account limits for traditional IRAs, Roth IRAs, SEP IRAs , SIMPLE IRAs, Keogh IRAs, and self-directed 401(k) plans do not change with the new legislation. These accounts are already insured by the FDIC up to $250,000 per person per bank. All retirement accounts owned by the same person in the same bank are added together and the total is insured up to $250,000. The same rules apply to IRAs as the single ownership bank accounts for different branch locations and separate banks. For this reason, multiple separate accounts up to the insured limit are encouraged at different banks.

Brokerage accounts with companies such as Charles Schwab or Ameritrade are also unaffected by the new legislation. These accounts are protected by the Securities Investor Protection Corp. (SIPC) instead of the FDIC. They are insured up to $500,000 per account with a $100,000 limit for any cash or money market amount. Since each account is protected up to the limit, multiple accounts will allow for greater insurance protection. If a brokerage firm fails, investors receive their share of the broker’s assets, and then the SIPC insures up to $500,000 per account to buy the same number of shares originally owned. Since brokers are required to hold more assets than liabilities and most brokers carry additional insurance, investors are likely to recover all of their original investment. Losses from poorly performing investments are not insured; the investor simply recovers the total shares owned before the brokerage failed. SIPC coverage excludes any investments or contracts that are not registered with the SEC.

EMERGENCY ECONOMIC STABILIZATION ACT

In October 3, 2008 the Emergency Economic Stabilization Act (EESA) of 2008 was signed into law. Although the centerpiece of the new law is the financial market rescue package, it included several important tax law changes, including alternative minimum tax (AMT) relief, extenders of expired and expiring business and individual tax provisions, and other tax law changes.

The 2008 Act boosts the AMT exemption amount and provides that personal nonrefundable credits may offset AMT and regular tax liability for 2008. This one year “patch” will help millions of middle-income taxpayers avoid AMT, and for those in AMT, it may lower their liability. As in prior years, it is a one -year fix, and the exemption amount for 2009 will revert to the levels they were in 2000 unless Congress takes further action. Also included with the AMT patch are additional relief positions for those taxpayers who were stung by AMT in a prior year by exercising incentive stock options (ISOs).

Many individual tax breaks expired at the end of 2007. EESA retroactively extends them for 2008 as well as for 2009. Tax breaks include:

The option of deducting state and local sales tax instead of state and local income taxes as an itemized deduction

• The deduction for qualified tuition and related expenses for higher education
  paid during the year
• The up-to-$250 educator’s
• deduction for classroom supplies paid out-of-pocket.
• The up-to-$100,000 annual exclusion from gross income for taxpayers age 70½ and older who make direct transfers of an otherwise taxable IRA distribution to a qualified charitable organization. The direct transfers satisfy the required minimum distributions for the year.

Certain expired business tax provisions extended for 2008 and 2009 include an extension of the Research and Development tax credit and a 15-year recovery life for qualified leasehold, restaurant, and retail space improvements.

EESA also extends and expands deductions and credits for residential energy savings improvements, such as insulation, doors, windows, and furnaces for 2009 only. There is no credit available for these improvements in 2008.

Casualty losses rules were also changed with the new tax laws. Individuals may deduct personal casualty losses or personal theft losses only if they exceed a $100 per event and 10% of your adjusted gross income (AGI) in the year of the loss. If a disaster occurs in a presidentially-declared disaster area, an individual may elect to take into account the casualty loss either in the year of the loss or in the preceding year. Before 2008, only those who itemized their deductions could deduct their casualty losses. EESA waives the 10% of AGI limit for victims of federally-declared disasters in 2008 and 2009, and will allow non-itemizers to claim a deduction for federal disaster losses. For 2009 only, the event limit changes from $100 to $500 per casualty. EESA provides a number of additional tax breaks for victims of the storms and flooding that pummeled Midwest states this year.

Lastly, after 2010, stock brokers must report the cost basis of any security purchased after 2010 as well as indicate whether a sale is long-term or short-term. Many brokers already provide this information, but on a separate gain/ loss schedule that is not submitted to the IRS. This change will affect you when you change stock brokers post-2010. You may need to provide cost basis info to the new broker so that they can comply with these provisions.

SALES TAX REFERENDUM

While the 2008 presidential elec-Most Milwaukee businesses currently tion had the most advertising charge sales tax of 5.6%, which is comand received the bulk of the media prised of a 5% Wisconsin sales tax, attention, an important sales tax refer-0.5% county tax and 0.1% stadium tax. endum on the Milwaukee ballot may The highest county sales tax allowed is have a more immediate effect on area currently 0.5%; however, this new ref-small businesses. erendum allows the State Legislature and governor to authorize an additional 1.0% sales tax in Milwaukee County only.

2009 RETIREMENT PLAN CONTRIBUTION LIMITS

The IRS has released the 2009 retirement plan limits, with most deferral and catch-up limits increasing over the 2008 amounts.

The referendum was intended to generate dedicated funding for county parks, buses and emergency medical services where there is a backlog of unfunded maintenance, with the tradeoff being $67 million of guaranteed property tax relief. To translate into dollars, a Milwaukee property owner with a house assessed at $250,000 could expect a reduction of $278 of property taxes assuming no change in assessment or tax rates between years. The property tax relief is potentially a zero sum game, assuming that same homeowner purchases around $28,000 of goods subject to sales tax.

This referendum does not automatically increase the county sales tax and is a direct cost to consumers as opposed to sellers. We can expect to see legislative attention to the county tax early in 2009 with possible enactment later in the year. We do not recommend any major changes in business purchasing decisions, but the possible increased sales tax does yield a slight competitive disadvantage to Milwaukee County businesses if enacted. We will keep you posted as to the progress of any sales tax legislation we may see in 2009.

TAX CREDIT FOR DIESEL CAR OWNERS

Many people know of the tax breaks available on hybrid vehicles created under the Energy Policy Act of 2006 in order to encourage the production and purchase of energy-efficient cars. You may not realize that some newer-generation diesel cars may also qualify for tax credits under the same act. Newer cars that run on low-sulfur diesel fuel have reduced emissions while increasing fuel economy. Diesel vehicles currently eligible for the credit include the Volkswagen Jetta TDI and Mercedes Benz GL320, ML320, and R320 Bluetec. Depending on the vehicle, credits range from $900 to $1,800, and the full credit is available only on the first 60,000 sold of each make. After the 60,000 sales limit is reached, the phase out limit kicks in, and a reduced credit is available until its complete phase-out.

When factoring in the tax credit into your purchasing decision, be aware that the credit can be limited or lost due to alternative minimum tax (AMT). If you are subject to AMT and unable to take the credit, there is no provision for a carryforward. If you are not subject to AMT, the credit is limited to the amount your regular income tax exceeds your AMT.

We anticipate that the list of eligible diesel vehicles will continue to grow. Let us know if you purchase an eligible new vehicle, as it may reduce your tax bill.

Komisar Brady & Co., LLP offers much more than high quality tax, accounting and auditing services. We offer many types of consulting services to businesses, including business succession planning, sale or acquisition of a business, long range forecasts and budgeting, and valuation services. We also offer estate and retirement planning and aid in the choice and implementation of qualified retirement plans for business owners and sole proprietors. If you have any questions in regards to your individual or business financial matters, please give us a call and see what we can do to help, or if we can direct you to someone who can.

This document provides information of a general nature. None of the information contained herein is intended or written as a tax opinion relative to specific issues addressed in this document.

To ensure compliance with Treasury Circular 230, we are required to inform you that any advice concerning U.S. federal tax issues contained on this website is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code and was not written to support the promotion or marketing of any transaction or matter discussed herein. Application of tax regulations is specific to the individual or business and we recommend that you consult a qualified Komisar Brady tax professional for how the above information may apply to you.