2007 Income Tax Planning

As we approach a presidential election year, many of the significant tax law changes incorporated in the Economic Growth and Tax Relief Reconciliation Act of 2001 remain subject to a sunset provision that will result in substantial tax rate increases over the next three years. For instance, beginning in 2011, the top ordinary and capital gains rates are scheduled to rise to 39 percent and 20 percent, respectively, and the federal estate tax rate will be increased to 55 percent, while the amount an individual may transfer to the next generation without incurring an estate tax will be reduced to $1 million.

Presumably fearful of the political ramifications and an increasing deficit, Congress has offered various pieces of legislation over the past several years that provide temporary solutions to serious tax law issues; these include the Alternative Minimum Tax (AMT). In fact, as this article goes to press, Congress continues to work on a bill that would provide an AMT patch for 2007 as well as extend several tax breaks in 2007, such as the research credit and the educator’s classroom deduction. To offset this patch, the bill would include provisions that would tax nonqualified compensation paid by offshore hedge funds to investment managers as well as tax, as ordinary income, the carried interest of private equity partners performing investment management services.

Taxpayers must remain focused on their personal income tax liability and those tax saving techniques that may minimize the inevitable financial burden many associate with April 15th. The 2007 year-end tax planning approach includes many concerns and techniques that were useful in previous years – such as the federal alternative minimum tax (AMT), capital gains and retirement planning – but also incorporates some of the new options resulting from recent legislation.

The Alternative Minimum Tax

When the AMT was enacted in 1969, it was designed to safeguard against the “very wealthy” exploiting certain tax incentives to avoid paying income tax. However, due to a failure to adequately index available AMT exemption amounts to fairly represent inflation, along with a phase-out provision for higher income tax earners and the recently reduced marginal rates, the number of taxpayers subject to AMT will dramatically increase over the next decade.

Under current law, the AMT personal exemption drops from $62,550 in 2006 to $45,000 in 2007 and 2008 for married couples filing jointly, and from $42,500 to $37,750 for single filers. As mentioned above, Congress is currently considering a one-year patch for the AMT, increasing the personal AMT exemption from $45,000 to $65,350 for married couples filing jointly and from $37,370 to $43,900 for single filers. Despite this potential patch, it is imperative that taxpayers consider the potential application of the AMT as year-end approaches.

Taxpayers who may be particularly vulnerable to the AMT are those who live in states with high income taxes (such as California, New York, Montana, Oregon and Vermont), high property taxes (such as New York, Illinois and New Jersey) and deductible personal exemptions. Other taxpayers prone to the AMT include those with large long-term capital gains or qualified dividends, large miscellaneous deductions, large deductions for accelerated depreciation and taxpayers who have exercised incentive stock options (the bargain element of an incentive stock option is not subject to ordinary income tax when exercised, but is subject to AMT). It is important to note that for 2007 through 2012, taxpayers who have a long-term AMT credit (originating in 2003 or earlier) may be eligible for a refundable credit equal to the greater of $5,000 or 20 percent of the unused minimum credit, subject to certain AGI phase-outs. This is primarily intended for taxpayers who received an AMT credit from the exercise of incentive stock options.

To adequately plan for the AMT, a taxpayer should not only project his or her income for the current year but for the next two years as well. Many of the techniques that may be used to avoid or alleviate the AMT entail the acceleration of income or the deferral of certain deductions that the AMT calculation does not recognize and should only be considered with the advice of a qualified tax advisor. For instance, if, based on the projections, a taxpayer expects to be subject to the AMT in 2007 but not in 2008, he or she should consider accelerating ordinary and short-term capital gain income and deferring certain non-AMT deductions – such as state and local income taxes, real estate taxes and investment advisory fees – to 2008.

Although this concept may seem counterintuitive to general tax planning principles, the imposition of the AMT rates on the ordinary and short-term capital gains income may provide a better tax result than if the taxpayer’s regular marginal rates applied. Conversely, if the projections determined that the taxpayer would not be subject to the AMT in 2007 but is likely to be subject to the tax in 2008, he or she should consider accelerating expenses that are not deductible for AMT in 2007.
For example, a taxpayer may want to prepay state income tax, property tax or home equity debt if the interest expense is not deductible for AMT purposes. Clearly, this analysis becomes more of a challenge until Congress provides some certainty regarding the status of AMT for 2007 and 2008. Until then, a taxpayer should instruct his income tax advisor to calculate various projections based on the current and potentially increasing personal AMT exemptions.

Capital Gains and Qualified Dividends

As in previous years, a taxpayer should evaluate his or her capital gains transactions from the sale of investments and consider offsetting the gains with year-end sales of capital investments that have a history of underperforming and will most likely produce capital losses. However, a taxpayer must be aware of the wash-sale rules if he or she intends to sell a loss position and reacquire the position within 30 days.

Although the current federal long-term capital gains rate generally remains at a favorable 15 percent, strategizing the timing of a taxpayer’s capital loss recognition not only alleviates a taxpayer’s overall tax liability but also may inspire a much needed rebalancing of an investment portfolio. In addition, it is also important to note that losses taken in excess of gains may offset ordinary income up to $3,000 ($1,500 for married individuals filing separately) and any remaining amount may be carried forward. Considering the capital gains tax rate change (described above) that is scheduled to occur in 2011 under current law, consideration should be given to the timing of recognition of gain in any long-term, appreciated asset that may otherwise be realized in three to five years.

Due to the capital gains and qualified dividend rate differential between taxpayers in the two lowest tax brackets (5 percent) and those in the highest four tax brackets (15 percent), taxpayers should consider transferring dividend producing appreciated stock to their children or grandchildren. The recipient will take the taxpayer’s basis in the stock transferred; however, if the recipient is over the age of 17 and in the lowest two tax brackets, the transfer could result in an immediate 10 percent tax savings on both capital gains and any dividends received following the transfer. Assuming the taxpayer has properly planned with his or her tax advisor to ensure that the transfer qualifies for the annual gift tax exclusion (and the annual generation-skipping transfer tax exclusion, if applicable), he or she will have successfully alleviated his or her tax liability, reduced the overall tax effect on the transferred asset and satisfied a family wealth transfer objective.

If the child is under age 18, however, any amount of the child’s unearned income (e.g., dividends, interest and capital gains) over $1,700 (the first $850 is not taxed and the second $850 is taxed at 10 percent – 5 percent for capital gains and qualified dividends) is subject to so-called “Kiddie Tax,” which either taxes the income at the parents’ top tax rate on the child’s return or adds such income to the parents’ income as ordinary income, qualified dividends or capital gain distribution on the parents’ return.

The Small Business and Work Opportunity Tax Act of 2007 further expanded the Kiddie Tax. Effective January 1, 2008, the Kiddie Tax will apply to children age 18 and younger, as well as to dependent college students under the age of 24. Therefore, taxpayers should pay close attention to the Kiddie Tax rules if the taxpayer has children who are currently between 18 and 24 years old, as he or she may want to consider taking advantage of the child’s lower tax bracket in 2007 before the option is eliminated in 2008.

Further, it is important to note that taxpayers may elect to treat capital gains and qualified dividends as investment income, which is taxed at ordinary income rates, if they have deductible investment interest expense available to offset it. Investment interest expense is only deductible to the extent of current year net investment income. Since capital gains and qualified dividends are not considered investment income for this purpose, a taxpayer may want to consider electing to recognize enough capital gains or qualified dividends as investment income to maximize the use of any available investment interest deduction while maintaining the character of any remaining capital gains and qualified dividends, which will continue to be taxed at the more favorable tax rates.

Retirement Planning

Contributions to traditional individual retirement accounts (IRA) and qualified retirement plans are an essential component of a successful financial plan, one that also may provide an opportunity to reduce the taxpayer’s current tax liability. A taxpayer should consider contributing to his own IRA, or a spousal IRA if his or her spouse has little or no earned income and is not currently participating in an employer-sponsored retirement plan.

The maximum contribution that can be made to each IRA is $4,000 for 2007 ($5,000 for individuals who have reached age 50), which may be applied retroactively if made before the tax filing deadline. However, the deduction for such contributions is phased out for married couples filing jointly who have adjusted gross income between $156,000 and $166,000 ($99,000 and $114,000 for single filers). Despite the loss of the tax deduction, the amounts contributed to the IRA will be permitted to grow in a tax-deferred manner, thereby still providing a good retirement planning option. Similarly, a taxpayer may want to consider a contribution to a Roth IRA if he or she is not restricted by the income limitations. Although contributions to a Roth IRA are not deductible for tax purposes, the income earned in the account may be free of federal income tax when the taxpayer makes withdrawals.

To take advantage of the benefits of a Roth IRA, which, in addition to tax-free earnings, also includes the option of making additional contributions to the account after age 70 1/2 and the avoidance of the mandatory distribution rules applicable to IRAs during the owner’s lifetime, a taxpayer may want to consider converting an existing IRA to a Roth IRA. Although the conversion will result in an immediate tax recognition, the added benefits of a Roth IRA described above may make this a useful wealth transferring vehicle. In 2007, only individuals with modified adjusted gross income below $100,000 may convert their IRAs to Roth IRAs; any minimum required distribution amounts received by the individual from IRAs will not count toward the $100,000 limitation.

Contributions to a qualified retirement plan, such as an employer-sponsored 401(k) or 403(b), are funded with pre-tax money and therefore are not includible in the taxpayer’s gross income. The maximum contribution to a qualified retirement plan is $15,500 for 2007 ($20,500 for individuals who have reached age 50) and such contributions must be made before the end of the calendar year. Similar to an IRA, the account grows tax-deferred. Therefore, the taxpayer is not taxed on his or her contributions and earnings until the taxpayer makes a withdrawal from the account.

It is important to note that an individual may be permitted (if offered by his or her employer plan) to allocate a portion or all of his contributions to a Roth 401(k) or 403(b). As with a Roth IRA, the contributions will be made with after-tax money but the distributions may be taken free of federal tax. Unlike a Roth IRA, a Roth 401(k) is subject to the mandatory distribution rules, which require that minimum distributions from the account must begin in the year following the year the participant turns age 70 1/2. However, a participant may roll over his or her Roth 401(k) to a Roth IRA to avoid having to make such distributions during his or her lifetime. Over time, this could result in more after-tax wealth.

Charitable Giving

Taxpayers can increase their charitable deductions by donating marketable securities that have appreciated in value to their favorite charity or a donor advised fund; they can take a deduction up to 30 percent of adjusted gross income for the securities’ fair market value on the date of the gift. The deduction is also allowed for AMT purposes. If, however, the securities were sold first and then the net proceeds contributed to the charity or donor advised fund, the taxpayer will generally incur either regular tax or the AMT on any capital gain.

The Pension Protection Act of 2006 permits individuals who are at least 70 1/2 years old to distribute up to $100,000 of their IRA balance to a charity tax-free (a charitable rollover). Although this provision is available only for 2006 and 2007, there is currently a proposal in Congress to extend this provision indefinitely. Taxpayers may not take an itemized deduction for the contribution and the amounts contributed are not includible with charitable contributions for purposes of applying the annual AGI itemized deduction limitations; however, the amount contributed will count toward the taxpayers required minimum distribution for 2007.

Situations where a charitable rollover may be worth considering include those in which the taxpayer’s retirement distributions make up a large part of his or her taxable income, those in which he or she is subject to a phase-out of itemized deductions, those in which he or she does not itemize deductions or itemizes only for the purpose of obtaining charitable deductions or those in which his or her IRA distribution results in higher taxation of social security benefits. Charitable rollovers may be made to public charities only, and not to donor-advised funds or private foundations.

It is also important to note that beginning in 2007, cash contributions of less than $250 will not be allowed unless the taxpayer retains a cancelled check, bank statement or receipt from the charitable organization that received the gift. Furthermore, in order to obtain a charitable deduction for a donation of used goods or clothing, a taxpayer must obtain confirmation from the charitable organization that the item was in good or better condition at the time of the donation.

Conclusion

Although complicated, year-end income tax planning is a necessary analysis, one that every taxpayer should undertake. With the assistance of a qualified tax advisor and an understanding of the current planning options and pending law changes, a taxpayer can greatly reduce his or her tax bill. The process should not only entail a discussion of this year’s income and options, but should also incorporate projections for the next two years to provide the most effective
planning.