Tax strategies after the Revenue Reconciliation Act of 1993. (includes checklists of business strategies) (Cover Story)by Wolitzer, Robert
Shortly after the tax return is filed for 1993 and the pain of higher taxes is still present, tax planning for 1994 should take place. The 1993 tax act has made the need for planning more crucial, and perhaps more beneficial than ever.
The Revenue Reconciliation Act of 1993 (RRA '93) did little for simplification. To some it may seem equity was served, since it increased the tax rates for those in higher brackets. Regular tax rates were raised to a maximum of 39.6%, but this is misleading. The 1.45% Medicare tax now has no cut-off point. Though a taxpayer may hit the Social Security maximum cap ($60,600 in 1994), the Medicare tax continues without limit.
RRA '93's only benefit was in the estimated tax area, and there is already talk of amending those provisions. It looks as if the taxpayer is last in the thoughts of Congress.
But there is no looking back. Tax planning and the use of strategies are more important than ever. The Alternative Minimum Tax (AMT) may spoil some strategies with the new rate of 28%, so a good planning job must consider all alternatives.
Conversion to Tax-Exempt Income
Municipal Bonds. The increase in tax rates makes municipal and state bonds more popular than ever. In localities with both state and city income taxes, interest on local bonds may become triple tax exempt. In addition, not having to include tax-exempt income in taxable income helps in salvaging a portion of personal exemptions and itemized deductions. Tax-exempt bonds are still not applicable as an AMT add-back except for private activity bonds issued after August 7, 1986.
Series EE U.S. Savings Bonds. The new law still allows the use of Series EE U.S. Savings Bonds for educational expenses. If property structured as to ownership and purchase dates, the interest income never has to be reported. The U.S. Savings Bonds must be redeemed to pay for qualified higher education expenses and is subject to phaseout for middle and upper income taxpayers.
Life Insurance. A life insurance policy is still one of the best tax shelters available. The policy's cash surrender value may build up equity tax-free. Taxpayers may borrow against this equity paying low interest rates on the loan, and receive monies without any tax consequences. The strategy is improved if ownership of the policy is kept out of the taxpayer's estate.
Deferring or Reducing Income
Bonus Income. Bonuses paid after January 1, 1994, will be subject to the 1.45% Medicare tax rate. The 1.45% rate will apply to all earned income beginning in 1994 without a maximum cap. Thus, the taxpayers may be better off receiving some nontaxable fringe benefits, deferring the bonus, or negotiating for stock options that can lead to capital gains. It should be remembered the 1.45% is on top of the 39.6% regular income tax rate.
Qualified Tax Deferred Plans. Tax deferral plans are always popular. Postponing the receipt of income does have some drawbacks. It reduces cash flow to the employee, and the employer must be willing to cooperate. Also, the employee is relying on the continued solvency of the employer. Elective deferrals under all cash or deferred arrangements in which a taxpayer participates are subject to annual limitation amounts. These are subject to cost-of-living adjustments each year. The beneficial effect of the interest earned on taxes deferred can add up to big dollars.
Corporate officers who serve as directors of other companies can shield some of their earnings by setting up a Keogh plan. The plan, however, must be set up before December 31 of the tax year, though contributions don't have to be made until the tax return is due which can be the extended due date.
Flexible Spending Accounts. Flexible spending accounts allow employees, including corporate officers, to contribute pre-tax dollars for specific purposes, such as child-care or health-care costs. Thus, taxable income can be reduced, while paying for items usually paid by after tax dollars. Careful planning is necessary to not lost excess money left in the accounts.
Gain on Sale of Personal Residence. The tax deferral on the sale of a personal residence, under IRC Sec. 1034, should be utilized wherever possible. If the taxpayer is over 55, the $125,000 one-time exclusion of gain is a definite plus.
Like-Kind Exchanges. Under IRC Sec. 1031, the use of like-kind exchanges can also lead to tax deferral. To qualify, the property must be held for productive use in a trade or business or for investment. The property received in the exchange must be of a like kind; it must be of the same nature or character or the same class. Replacement property must be identified within 45 days of the transfer of the old property and must physically be received by the taxpayer within 180 days or, if earlier, the due date (including extensions) for the transferor's tax return for that year. Three replacement properties per year may be identified or an unlimited number of replacement properties, if their aggregate value is less than or equal to 200% of the aggregate value of the relinquished properties. Real property under construction also may qualify. Of course, if cash flow is important, an outright sale resulting in capital gain may be preferable. In addition, it might be more advantageous for the taxpayer to go for the sale of the property and thereby incur a long-term capital gain to offset capital losses.
Group Life Insurance. Group life insurance premiums paid by the employer are nontaxable to the employees for policies with coverage of under $50,000 of insurance. If the coverage is over $50,000, the employee is taxed. But the amount is minimal in relation to the protection offered to the family.
Maximizing Long-Term Capital Gains
Long-term capital gains are popular again because of the spread between the 28% long-term capital gains rate and the top rate of 39.6% on other income. The 39.6% is really in excess of 40% when you factor in the 1.45% Medicare tax on all earned income and the loss of personal exemptions and itemized deductions. Timing of capital gains and losses can create a strategy whereby capital gains will be taxed at a maximum of 28% whereas net capital losses up to $3,000 each year can be deducted against ordinary income. This will work only if the gains and losses are recognized in separate tax years, which may not always be possible. Growth stocks are more attractive from a tax perspective over income- producing equities. Dividends are taxed at ordinary income rates whereas the gain on sale of growth stocks will trigger the 28% capital gains rate.
Puts. One example of how to convert short-term capital gains into long- term capital gains is with put options. Assume the taxpayer has a substantial short-term paper profit on 1,000 shares of ABC stock purchased on November 15, 1993. She feels this stock is likely to go down in price in the near future. Let's say the taxpayer has a holding period of 11 months and an unrealized capital gain of $100,000.
The taxpayer is in a marginal Federal tax bracket of 42.6% for a short- term capital gain. The tax cost would be $42,600 versus $28,000 for a long-term capital gain, a difference of $14,600. All that is needed is to hold the stock for an additional month and one day, provided the price does not decline.
A put is an option to sell stock at a set price (strike price) at any time up to a specified expiration date. Each put represents 100 shares of stock. The market value of a put is a function of--
* The market price of the stock relative to the strike price, and
* The period of time until expiration.
In the above example the taxpayer can purchase 10 puts of ABC stock, locking in the selling price at $115 per share as shown below:
If the taxpayer sells 1,000 shares of ABC stock on November 18, 1994, she will recognize a long-term capital gain of $100,000. She will also have an offsetting short-term capital loss of $3,750 when the puts expire on November 19, 1994. In this example, if the market value of ABC stock falls to $108 per share on November 18, 1994, the taxpayer is clearly ahead.
If the put options had not been purchased, the taxpayer's position would have been as follows:
If the sale had been made on September 15, 1994, the results would have been:
The above scenario depends upon a judgment call by the taxpayer as to how much he feels the market price of the stock will drop in the near future. In addition, the taxpayer could defer the realization of the capital gain until 1995 by purchasing a put expiring in January, 1995. This put, however, would be more costly (maybe $5 3/4 or two extra points) because there would be more of a time premium.
Finally, if the stock does go up in value (over the $115 strike price of the put) the taxpayer can sell it at the higher price by not exercising his right to sell the stock via the options. Only the cost of the puts reduced by the tax break on the capital loss is lost.
Married Put. Another convention that may be utilized is the "married put." This is a conservative approach where the taxpayer buys a put on a stock the same day the stock is purchased. The stock should be identified as being intended to be used in exercising the put.
As mentioned before, the higher the put's strike price and the greater the length of time the put has before it expires, the greater the cost. However, the put will also provide more insurance for the taxpayer's long position. Puts with an expiration date over a year are a relatively new convention; they are called "leaps" and are available for only a few issues.
If the stock goes down in price and the put is sold within less than a year, the taxpayer may realize a short-term capital gain on the sale of the put. The taxpayer may wish to still hold the stock. The stock position is then free of the put. The taxpayer also has a second option of exercising the put by selling the stock at the put's stock price. In this case, the cost of the put reduces the amount realized upon the sale of the underlying stock. Finally, if the put expires worthless, the taxpayer has incurred capital loss. The stock position is then free of the put and on its own.
Covered Calls. Another strategy is the use of "covered calls." A call is an option purchased by the holder to obtain the right to purchase a certain number of shares of stock at a stated price (strike price) within a certain time (until the expiration date). A "covered call" is a call sold by an individual that owns the underlying stock (the writer). If a "covered call" is exercised, its proceeds are added to the seller's amount realized. If the seller has a long-term holding period, the proceeds of the covered call are also considered part of the long-term capital gain. An example follows:
If in the above example, ABC stock is selling for less than $33.50 per share, the taxpayer is clearly ahead of the game. The taxpayer, however, as the writer of the call, does not have the right to exercise the option. This right belongs to the holder or buyer of the option.
IRC Sec. 1256 Contracts. IRC Sec. 1256 contracts have a holding period determined by statute, not the actual time held by the taxpayer. The capital gain is always 40% short term and 60% long term. These transactions are reported on Form 6781. They include regulated future contracts, foreign currency contracts, and nonequity options. The benefit here is that 60% of profits are considered long-term capital gains even though the taxpayer may close the transaction the next day.
Straddles. A straddle is created when a taxpayer has positions in personal property, including stock and stock options, that balance or offset each other. Under IRC Sec. 1258, transactions entered into after April 30, 1993, cannot convert ordinary income into capital gains with straddles. These rules do not apply to dealers of options in their normal trade or business. IRC Sec. 1092 goes further in stating loses incurred from actively traded personal property are deferred to the extent the taxpayer had gains in offsetting positions that were not closed out by year-end.
Sales of Businesses. When long-term capital gain rates are lower than ordinary income rates, buyers want to maximize and accelerate their deductions while sellers want to maximize their long-term capital gains. In such an environment, these transactions have been structured to reduce the sales price and pay the seller a consulting fee or a salary continuation. This is justifiable as the seller's services are needed during the transition period while the new owner takes over. Of course, the amount paid must meet the reasonable compensation test. By paying the seller over a number of years, the seller gets some deferral of income and the buyer gets deductions.
In addition to consulting agreements, covenants not to compete have typically been used. A major provision of RRA '93 changes the consequences of covenants not to compete. Under the tax act, certain assets, including covenants not to compete, are now treated as IRC Sec. 197 intangibles, subject to 15-year amortization, if they arise in connection with the acquisition of a business.
Also under these new IRC Sec. 197 provisions, the seller can now have more leverage in negotiating sale agreements stressing long-term capital gains, since the buyer can derive tax benefits from the 15-year amortization of goodwill. Previously, goodwill was not deductible for tax purposes. Buyers may, however, still stress consulting agreements in order to accelerate deductions over a period less than 15 years.
Maintaining or Increasing Deductions
Adopting LIFO. Use of the LIFO inventory method has many advantages. During inflationary periods, the LIFO costing method results in closing inventory that is priced lower than FIFO. The increase in cost of goods sold results in a lower income, lower taxes, and increased cash flow.
Inventory Donated to Charity. Inventory exceeding customers' current needs should be considered as a candidate for a charitable deduction. The result can be much more advantageous than selling the inventory at temporarily depressed prices. Under IRC Sec. 170(e)(3), the taxpayer may take a deduction for the basis in the property plus one-half of the property's unrealized appreciation. However, the deductions may not exceed twice the taxpayer's basis in the property, and no deduction is permitted for property appreciation resulting from ordinary income recapture. The donation must be made to qualifying public charities or private operating foundations. The donee's use of the property should be for the care of the needy, the ill, or infants.
Qualified Research Contribution. In general, under IRC Sec. 170(e)(4), a qualified research contribution may also be made to an institution of higher education or to an exempt scientific research organization. The donor must have constructed the property for the donee's use and the property must be donated within two years of completed construction.
Gifts of Appreciated Property. Gifts of appreciated property to charity benefits both the charitable organization and the taxpayer. All gifts, which can include art, real estate, stocks, bonds, and other collectibles (capital-gain property), should be for the use and benefit of the charity. The taxpayer can deduct the fair market value of the gift. Thus, if the tax basis is $10,000, and the FMV is $100,000, the charitable deduction is $100,000. It does this without triggering the AMT.
If, however, a taxpayer wants to give to charity an asset that has decreased in value, better tax planning suggests the taxpayer sell the asset, take a tax loss, and then distribute the cash to charity.
IRC Sec. 179 Election. Effective January 1, 1993, an IRC Sec. 179 election may be made to expense $17,500 in tangible personal qualifying property placed in service for that year. Property placed in service should not exceed $200,000 and the amount expensed may not exceed the taxpayer's annual taxable income from compensation for services or the active conduct of any trade or business (determined without regard to this provision). There is a carryover to future tax years of any unused expense.
Executive Compensation. Effective January 1, 1994, there is a one million dollar deduction cap on top executive compensation for publicly traded companies. Executive pay over the one million dollar cap may be deductible if it is reasonable and based upon performance goals drafted by a committee of independent directors. It also must be approved by shareholders.
Various methods may be employed to preserve this deduction:
* Deferral of compensation: Executives may postpone annual bonuses to a year when their compensation falls below $1 million.
* Use of a two-tier bonus arrangement: One tier bases an executive's annual bonus on performance that must be determined objectively and approved by shareholders. A second tier is discretionary and maximizes at the $1 million cap.
* Use of stock option plans: The maximum number of options received annually must be predetermined.
Self-Employed Health Insurance Costs. RRA '93 retroactively reinstated some expired tax provisions. The 25% deduction for health-insurance costs by the self-employed and S corporation stockholders (owning more than 2%) is reinstated.
Empowerment Zones and Enterprise Communities. The Act also creates up to nine empowerment zones and 95 enterprise communities to be designated in 1994 and 1995. Qualified businesses can expense an additional $20,000 of IRC Sec. 179 property used in a zone or community. Also, employers receive an employer wage credit of 20% of the first $15,000 of wages to each employee who works and lives in the zone or community. Designated zones and communities are those that suffer from pervasive poverty, unemployment, and general distress. A similar type employee wage credit and accelerated depreciation will apply to businesses on or near Indian reservations. New businesses can be created to take advantage of these provisions, benefitting the community as well as the business owner.
Companies located in enterprise zones also will be able to finance property with a new category of exempt facility private activity bond.
Itemized Deductions. Itemized deductions in excess of the standard deduction are still valuable to the taxpayer, especially in the upper brackets. The strategy of bunching deductions subject to floors or limitations can still work to the taxpayers advantage. These include medical and dental expenses, investment interest expense, gambling losses, and nonbusiness casualty and theft losses.
Points. If a taxpayer takes out a loan to buy a main residence, the points paid from personal funds are fully deductible. If the taxpayer is refinancing a mortgage, however, the points paid have to be amortized over the term of the loan. If there is a second refinance, the points still not deducted from the first refinancing can be deducted in the year in which the second refinancing occurs.
Spreading Income. Taxpayers can lower their tax bills by spreading income among family members. Thus, if a spouse and children are active in the business, they are entitled to a reasonable salary. It should be noted that services performed by a child under 18 in the employ of a parent is exempt from FICA tax. Net income not paid out as salaries can be shared through the utilization of a S corporation as a pass-through entity.
It should be noted that the "kiddie tax" comes into play for income of a child under 14. Not to be overlooked is that a C corporation with taxable income of up to $50,000 only pays a 15% corporate tax rate and from $50,000-75,000 pays a 25% corporate tax rate.
Filing Status. A taxpayer who has been recently widowed or divorced tends to think they must file as single. The taxpayer may be eligible to file as a head of household or surviving spouse. Both allow the use of a better standard deduction and lower rates. Married couples may find filing separately increases the benefit of dependent and itemized deductions and also avoids the AMT.
Overcoming the Marriage Penalty. For taxpayers contemplating marriage, January 1, 1995, should be considered as the date to tie the knot. The "marriage penalty" has not been decreased by Congress. Instead, the new 39.6% (or higher) tax bracket increases this "penalty." A New Year's Eve wedding may be romantic, but a New Year's Day wedding has financial advantages.
Retroactive Provisions. Refunds are always welcome, and for the taxpayer who has deductions based on the retroactive changes in the RRA '93, an amended return may be in order. These retroactive changes include:
* The exemption, from AMT of certain charitable gifts of appreciated tangible property including art work, antiques, collectibles, etc.
* Elimination of the luxury excise tax on jewelry, furs, boats, and aircraft.
* The deduction of 25% of self-employed health care costs (and greater than 2% shareholders in S corporations).
* Exclusion from income of employer-provided educational assistance (up to $5,250).
* Low-income housing credit.
Net Investment Income. Long-term capital gains are no longer considered a component of net investment income for limitation purposes in the deductibility of investment interest expense, unless a special election is made. If this election is made, long-term capital gains are treated as ordinary income and subject to possibly higher income tax rates. However, the taxpayer making the election will receive a higher investment interest expense deduction.
"Net investment income" is defined as investment income less investment expenses. Investment expenses directly connected with the production of net long-term capital gains are excluded from investment income (under these new rules), and should not be included in investment expenses for purposes of this calculation. This is an important planning strategy as the net investment income limitation will be increased by not including these expenses. Therefore, the taxpayer can utilize a higher current investment interest expense deduction. Investment advisory fees are an example of such an expense, and their exclusion may lead to a much greater amount of tax savings.
Classification as a Trader. Using the classification "trader" rather than "investor" is an excellent strategy if it can apply. A "trader" is a very active securities investor, so active the securities transactions reach a volume and/or take so much time as to constitute a "trade or business" for tax purposes. The trader classification is purely judicial determined by court cases. It carries with it a number of tax advantages and few, if any, disadvantages.
A "trader" does not have investment interest subject to deduction limitations, but "trade or business" interest. A "trader" has no investment expenses subject to a "two percent floor" and a "three percent phaseout" provision, but ordinary and necessary business expenses. A "trader" has no personal casualty losses, but business casualty losses. In addition, a "trader" may qualify for "home office" deductions and may expense, rather than depreciate, office typewriters, calculators, computers, and other equipment. Despite all these tax advantages resulting from being a self-employed "trader," the taxpayer still generates capital gains and losses and is exempt from self employment (Social Security) taxes.
A recent case, Ropfogel v. United States, 1991, identifies the following factors favoring "trader" status:
* Average holding period of securities (the shorter the better);
* Whether short-term or long-term profits were expected;
* The extent of financial leverage employed;
* A taxpayer's intent to derive income from frequent trading;
* Listing "trader" as the profession on the tax return;
* Filing a Form 1040, Schedule C;
* The existence of a business office;
* Spending a substantial amount of time on securities transactions on a regular and continuous basis by engaging in almost daily trading.
Real Estate Professionals. Beginning after 1993, taxpayers classified as real estate professionals are no longer encumbered by the passive loss rules. To qualify for this exception, the taxpayer must meet the following requirements:
1. More than one-half of the "trade or business" personal services performed by the taxpayer during the tax year must involve real property in which the taxpayer materially participates, and
2. Such material participation involving real property must comprise more than 750 hours of service.
These two requirements must be satisfied completely by one spouse if a joint return is filed. Planning can be used effectively here by having one spouse run all the rental properties while the other spouse pursues another occupation. Assuming the requirements for the exception are satisfied, the passive activity loss rules are applied as if each interest of the taxpayer in rental real estate is a separate activity, unless the taxpayer elects to treat all interest in rental real estate as one activity. The use of planning for this election is important since the substantial disposition of an activity frees up unused passive losses.
Limited Exception to Passive Loss Rules. The limited exception to the passive loss rules for taxpayers who actively participate in management decisions in a property is also available. Up to $25,000 of passive losses for rental real estate activities may be currently utilized to offset nonpassive income. The taxpayer must own at least a 10% interest in the activity and the $25,000 maximum is reduced 50% by the amount by which the taxpayer's modified adjusted gross income exceeds $100,000. For marrieds filing separately, the limitations are $12,500 and a $50,000 modified AGI.
Checklists Can Help
Two checklists are presented that include the points covered in this discussion as well as others. These checklists are not all inclusive and are intended merely to jog the memory. Planning is dynamic and requires imagination that goes far beyond checklists.
CHECKLIST OF STRATEGIES--INDIVIDUALS
* Use tax-exempt municipal bonds.
* Use qualified U.S. savings bonds for educational expenses.
* Consider investing in a life insurance policy.
* Since Medicare tax has no limit to the 1.45% rate, minimize salary income.
* Maximize contributions to retirement plans, and use IRA, Keogh, 401(k) plans.
* Use flexible spending accounts for payment of medical and child-care expenses
* Take advantage of tax deferral of gain on sale of personal house-- also $125,000 exemption of primary residence if over 55.
* Use like-kind exchanges rather than sales.
* Maximize long-term capital gains by using puts, calls, and straddles.
* Use excess capital losses up to $3,000 against ordinary income
* Stay under cut-off levels for earnings limits if collecting Social Security Benefits under age 70.
* Use installment sale reporting.
* Give appreciated property to charity.
* Use self-employed health insurance deduction where applicable.
* Bunch deductions not subject to two-percent floor.
* Consider if points are deductible in a refinancing.
* Use Schedules C, E, and F to avoid 2% reduction on miscellaneous itemized deductions.
* Consider if any home office expenses are deductible.
* Use home-equity loans for deductible interest.
* Shift income to parents and/or minor children while avoiding "kiddie tax."
* Check filing status if recently widowed or divorced.
* Consider effect of losing investment interest deduction when there are long-term capital gains.
* Determine if classification of trader is possible.
* Consider if classification as a real estate professional is appropriate.
* Determine if exceptions to passive loss rules for real estate apply.
* Base estimated tax payments on actual quarterly earnings.
* Request quick refund of overpaid estimated tax payments.
* Pay taxes on exact due date to earn interest as long as possible.
* If withholding is kept low for year, use additional withholding at end of year.
* Turn hobby into a business.
* Use annual gift tax exclusions.
* Use offer-in-compromise agreements.
* Consider if earned income tax credit is available.
CHECKLIST OF STRATEGIES--BUSINESS
* Use new rules for amortization of intangibles to justify higher sales price when selling a business.
* Provide group life insurance policies for employees.
* Use LIFO inventory method.
* Use excess inventory for charitable deduction.
* Use qualified research contribution.
* Take small business equipment expensing election under IRC Sec. 179.
* Consider methods to be used to preserve deduction for executive compensation subject to $1 million cap.
* Determine if business can take advantage of empowerment zones and enterprise communities.
* Use company dining room to avoid 50% reduction.
* Use two cars, one personal, one business, to substantiate deductions for car expenses.
* Use common paymaster--one corporation to handle payroll and payroll taxes.
* Weigh use of S corp vs. C corp. Also, consider possible use of LLC if allowed by state law.
* Use captive leasing company.
* Use medical reimbursement plan to avoid 7.5% reduction for employees on their returns
* Use targeted jobs credit.
* Establish an ESOP.
* See if corporation can qualify as a small business corporation under IRC Sec. 1244.
* Use Rev. Rul. 93-12 when valuing a minority interest in a family corporation to save gift and estate taxes.
Philip Wolitzer, CPA, is Professor Emeritus at Long Island University and a Visiting Professor at Marymount Manhattan College. Robert Wolitzer, CPA, is tax supervisor and researcher with Lopez, Edwards, Frank & Co. He is a member of the AICPA and NYSSCPA and serves on several committees of the latter.
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