11-29-07
Your Year-End Tax and Estate Planning To Do List
Our clients know that staying on top of tax and estate planning is a year-round endeavor. Still, many opportunities must be addressed prior to year-end or they may be lost.
Income Tax Considerations
Prior to implementing any tax plan, perhaps the most important step any individual or business can take is to conduct a full assessment of their current tax situation. Such an assessment should include a review of current year income and deductions (including capital gains and losses); an estimate of income and deductions for future years; a review of any carryover items (e.g., net operating loss or charitable contribution carryover); and identification of taxable items for which you can control the timing.
Once you have a full understanding of your current tax position, you will be able to make more informed decisions about what steps should be taken to minimize your tax exposure going forward. Below is a brief summary of some planning opportunity you may consider prior to year-end.
Accelerate Deductions and Defer Taxable Income
By deferring taxable income into a future year or accelerating deductions, you can reduce your current tax liability. Taxes can be paid in a later year allowing you to invest the savings in the interim. One common method for accelerating deductions is for taxpayers to make estimated tax payments for their 4th quarter state tax liability prior to year-end (ahead of the January 15 due date). You can claim a deduction for state taxes paid on your 2007 federal return.
While it is generally preferable to minimize current year taxable income, remember to keep track of any carryover items generated in prior years. Some items terminate after a specified period of time. An individual or business would not be well advised to defer income to a later year or accelerate deductions into the current year only to see a loss carryover expire.
Make 2007 Deferral Elections for Non-Qualified Deferred Compensation Plans
Many employers allow their executives to defer a portion of their compensation each year through non-qualified deferred compensation plans. If you are eligible to participate in a non-qualified deferred compensation plan, you are generally required to file your 2008 deferral election on or before December 31, 2007.
Additional Time Allowed to Amend Non-Qualified Deferred Compensation Plans
Final regulations applicable to non-qualified deferred compensation plans were issued during 2007. The regulations provided that plan documents for non-qualified deferred compensation plans needed to be reviewed and amended (if necessary) not later than December 31, 2007 to comply with the final regulations. In order to provide employers with sufficient time to analyze all their plans and make informed decisions regarding changes that would be necessary to bring those plans into compliance with the final regulations, the Service has recently announced an extension of time through December 31, 2008 to amend plan documents for compliance with the final regulations. If you are an employer with non-qualified deferred compensation plans, you should begin reviewing these plans now to insure you have sufficient time to make any necessary revisions within the extended time frame.
Gifts to Charity
A charitable contribution made before year-end can be claimed as a deduction on your 2007 income tax return. Also, by contributing publicly traded stock to a charity, you will avoid tax on the stock’s appreciation and be able to deduct the full value of the stock. Regardless of the type of contribution, you must maintain a proper record of your gifts. Beginning in 2007, a donor contributing money to a charitable organization (regardless of the amount) must maintain a cancelled check, bank record or receipt from the donee organization showing the name of the donee organization, the date of the contribution and the amount of the contribution. If you give a non-cash gift, ask for a letter estimating the value of the gift. Gifts over $5,000 that are not cash or publicly traded stock require an appraisal.
Tax-Free Distributions From IRAs for Charitable Purposes
Through 2007, individuals age 70½ or older are permitted to make direct transfers of up to $100,000 annually from their individual retirement account to a charitable organization. By distributing funds directly from their IRA to charity, the distribution is not included in the donor’s taxable income. Conversely, the donor is not allowed to claim a tax deduction for the charitable contribution. Previously, if an individual wished to contribute IRA assets to charity, the individual was required to take a distribution from his IRA and then contribute the proceeds of that distribution to charity. The individual would be required to include the distribution in income, but was allowed a deduction for his contribution. Unfortunately, the deduction in many cases would not fully offset the additional income because of (among other things) the phase-out of itemized deductions for high-income taxpayers.
Review Capital Gains and Losses
Review your portfolio for gains and losses you have recognized as a result of sales during 2007. When conducting this analysis, keep in mind that mutual funds are expected to make large distributions of capital gain income prior to year-end. To the extent you are in a net gain position, consider selling securities that have generated losses. Conversely, if you are in a net loss position or if you have capital losses that were suspended from prior years, consider locking-in some gains realized in 2007 by selling appreciated stock. You can utilize previously suspended capital losses to offset these gains. Corporations with suspended capital losses should always consider strategies to generate capital gains since corporations are only allowed to carry forward capital losses for 5 years. There is no time restriction on an individual’s ability to carry forward a capital loss.
Taxable Distributions from Mutual Funds Expected to Surge
When estimating your income, keep in mind that taxable distributions from mutual funds are expected to surge in 2007. Each year, mutual funds distribute substantially all of their income and net capital gains to shareholders. Investors who hold funds in taxable accounts must pay tax on these distributions, even if they reinvest the distributions in the same funds. Mutual fund investors may get a sense of their potential taxable distributions by searching the fund’s web site, which oftentimes provides investors with an estimate of the fund’s taxable distributions for the year.
0% Long-Term Capital Gain Rate in 2008 for Low-Income Taxpayers
In 2003 Congress lowered the maximum long-term capital gain rate (for most but not all dividends and capital gains) to 15%. For lower income taxpayers (those in the 10% or 15% ordinary income tax brackets), the long-term capital gain rate was reduced to 5%. Beginning in 2008, the long-term capital gain rate for lower-income taxpayers will be 0%. While not applicable to many taxpayers, the 0% capital gain rate represents a planning opportunity for many, including retirees, prospective retirees, and parents and children. If you or a family member are in a lower-income tax bracket, you may consider selling securities in 2008 to take advantage of the 0% tax rate.
Max Out Your 401(k)
Consider contributing the maximum amount to your 401(k) plan. The contribution limit was increased to $15,500 in 2007. In addition, individuals who will be at least 50 years of age by the end of 2007 may make an additional “catch-up” contribution of $5,000 in 2007. In 2008, the contribution limit remains at $15,500 and the catch-up contribution limit remains at $5,000.
“Kiddie Tax” Extends its Reach
For 2007, a dependent child under age 18 is taxed at their parents’ highest marginal tax rate on any unearned income in excess of $1,700 (prior to 2007, the kiddie tax applied only to children age 14 and younger). Beginning in 2008, the kiddie tax will extend its reach again to reach dependents under 19 years of age and full-time students under the age of 24. This change will impact those who were planning to sell securities in 2008 to take advantage of the special 0% tax on long-term capital gains for low-income taxpayers (see discussion below). If you have a child that is between age 18 and 24 this year and were planning to sell securities in 2008 to take advantage of the 0% tax on long-term capital gains, you may instead consider selling securities prior to year-end to take advantage of the current 5% tax on long-term capital gains for low-income taxpayers.
Avoid Underpayment Penalties
Make sure that you have paid enough in federal and state withholding taxes to avoid penalties. For 2007, you will avoid a penalty for the underpayment of estimated tax if your tax payments (including withholdings) have been timely made and are at least equal to 100 percent of the tax shown on your 2006 federal income tax return (110 percent, if your adjusted gross income for 2006 exceeded $75,000 if you were married, but filed separately, or $150,000 for other taxpayers) or 90 percent of the tax shown on your 2007 federal income tax return, whichever is less.
Recent Legislative Proposal Would Do Away with Alternative Minimum Tax
Over the past several years, the alternative minimum tax (or “AMT”) has been the subject of increasing criticism as more and more taxpayers have fallen subject to the tax. Congressman Charles Rangel, Chairman of the House Ways & Means Committee, has recently outlined a proposal to eliminate the alternative minimum tax for 2008 and subsequent years. In order to offset revenues lost on termination of the AMT, the proposal would assess a surcharge on high-income taxpayers. For married couples, the surcharge would be 4% of adjusted gross income (“AGI”) over $200,000 and 4.6% of AGI over $500,000. The surcharge would apply to all income, including capital gain and dividend income. This means that the effective capital gains rates for higher-income individuals would be 19 and 19.6%. We will provide updates on any developments with this or any other proposal related to the AMT.
Estate & Gift Tax Considerations
No Change to Federal Estate Tax
We still have a Federal estate tax. This year, the estate tax was not repealed nor did Congress revise the current Code provisions. The death tax-free exemption amount is $2 million for 2007 and 2008 and is scheduled to increase to $3.5 million in 2009. The top estate tax rate is 45% for 2007. Under current law, the estate tax is scheduled to be repealed for one year in 2010, but reverting to its pre-2001 Tax Act level of only $1 million per taxpayer for persons dying in 2011 or thereafter, with a top rate of 50%. While there has been a great deal of talk over the past several years regarding the estate plan, it is doubtful that any substantive legislation will be enacted until after a new administration takes office.
Annual Exclusion Gifts
In 2007, you may make a gift of $12,000 to any individual and certain trusts without any gift tax consequences. Married individuals may make gifts of up to $24,000. Gifts may be made outright or in trust and may be in the form of cash, securities, real estate, artwork, jewelry or other property. Giving property that you expect to appreciate in the future is an excellent way of utilizing your annual exclusion gifts because any post-gift appreciation is no longer subject to gift or estate tax. To take advantage of your annual exclusions for 2007, gifts must be made by December 31. Gifts over $12,000 or gifts that will be “split” between spouses must be reported on a gift tax return, which must be filed in April 2008.
Payment of Tuition and Medical Expenses
In addition to annual exclusion gifts, you may pay tuition and medical expenses for the benefit of another person without incurring any gift or generation-skipping transfer ("GST") tax or using any of your estate or GST tax exemption. These payments must be made directly to the educational institution or medical facility. There is no dollar limit for these types of payments and you are not required to file a gift tax return to report the payments.
Contribute to 529 Education Savings Plan
In planning for the future college costs of a child or grandchild, consider contributing to a 529 Education Savings Plan. So long as assets are used for qualified educational expenses, assets in a 529 Education Savings Plan grow tax-free (not just tax-deferred). Qualified educational expenses include tuition, fees, and books for a post-secondary education. Contributions are considered completed gifts and excluded from your taxable estate. You can contribute up to $60,000 ($120,000 for married couples) per beneficiary in a single year without incurring federal gift tax provided no further gifts are made to the same beneficiary over the next five year period. In addition, Illinois residents contributing to any of the Illinois 529 Plans (“Illinois Bright Start College Savings Program”, “Illinois Bright Directions Program” or “CollegeIllinois! 529 Prepaid Tuition Program”) are allowed a deduction for state income tax purposes of up to $10,000 ($20,000 if married filing a joint tax return).
Tax Benefits of 529 Education Savings Plans made Permanent
One of the primary benefits of a 529 plan is that assets are allowed to grow tax-free (not just tax-deferred). The “tax-free” benefit of 529 plans was scheduled to expire in 2010. This benefit, however, was made permanent during 2006.
Lifetime Gifts Using Gift Tax Exemption
In addition to annual exclusion gifts and the payment of tuition and medical expenses, individuals are also allowed a lifetime gift tax exemption. The gift tax exemption amount is currently a flat $1 million and is scheduled to remain at that level through 2010. Many clients make use of their $1 million lifetime exemptions by gift strategies such as Grantor Retained Annuity Trusts (discussed below) and other techniques that leverage the use of the exemption. A gift of appreciating property during your lifetime removes all future appreciation from your taxable estate at your death.
Generation Skipping Tax
The generation-skipping transfer (“GST”) tax is still in place. Generally, the tax applies to lifetime and death-time transfers to or for the benefit of grandchildren or more remote descendants, at a 45% flat rate for 2007. The tax is in addition to any gift or estate tax otherwise payable. However, each taxpayer is allowed a $2 million GST tax exemption for 2007-2008, which is scheduled to increase to $3.5 million in 2009.
Consider Lifetime Gifts that take Advantage of both the Gift Tax Exemption and GST Exemption
Many clients utilize their $1 million gift tax exemption ($2 million for a married couple) by structuring long-term GST exempt trusts benefiting multiple generations. Such trusts will remain exempt from all gift and estate tax as long as the trust remains in existence. Under Illinois law, such trusts can last in perpetuity, thereby allowing you to create a family endowment fund for your children, grandchildren and future descendants.
This article was prepared by members of the BWM&S Wealth & Succession Planning and Taxation practices. Its members include Karen MacKay, Stephanie Denby, Jonathan Michael, Martin Ryan, Melanie Witt, Julia Turk, Greg Winters, and Melissa Cover Selinger. Contact your attorney or any of the attorneys listed above at (312) 840-7000 or www.burkelaw.com/attorneys.
