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Year-end tax planning is always a good idea, but it can be especially rewarding this year, since it was a banner year for tax developments.
As a result of the American Jobs Creation Act of 2004 and the Working Families Tax Relief Act of 2004, there have been more tax law changes enacted this year than at any time since 1986. The IRS also has had a big year, issuing a flood of tax rules and guidance. Rather than being overwhelmed by these record-breaking events, there are significant opportunities for individuals and businesses to lower their overall tax payments and avoid new tax traps--and year-end tax planning is the key.
"By this time of year, taxpayers have a fairly accurate view of how their income and deductions for the year will turn out," noted George Jones, J.D., a senior tax analyst at CCH. "Armed with this snapshot, they can craft certain tax-planning steps to alter the results more in their favor. And, with legislation as an added variable this year, year-end tax planning offers many more opportunities to save overall taxes in this way."
According to Jones, three reasons make year-end planning more important than ever this year:
- Last-Minute Opportunities -- Legislative changes in the tax law make certain tax breaks available only through December 31, 2004. Act now, or never again.
- New Year, New Isssues -- Legislative changes create certain opportunities or pitfalls that start on January 1, 2005. Preparation can give you a head-start on both fronts.
- Traditional Considerations -- You should not lose focus on traditional year-end tax planning techniques, especially as they apply to differences in your individual tax profile since last year.
Last-Minute Opportunities
Legislation this year has created a long list of things you must do now to take advantage of tax breaks that either run out at the end of the year or are limited by annual amounts that start again in 2005. Here’s a look at some of the items that will affect tax situations:
- Bonus Depreciation -- Bonus depreciation can be of tremendous value to a business. A full additional 50 percent of the cost of business equipment and other property, in addition to regular depreciation, may be written off in the year of purchase. Bonus depreciation ends, however, on December 31, 2004, and it isn’t being renewed. If your business is planning a purchase, doing it in 2004 rather than in early 2005 may save you thousands of tax dollars.
- Vehicle Donations -- Starting in 2005, your deduction for a vehicle contributed to charity for which you are claiming more than a $500 deduction will be limited to the price the charity gets for selling it. If you’re thinking of donating a used car or truck, do it by the end of this year if possible, when you still can deduct its full fair market value.
- State Sales Taxes -- Up until 1987, taxpayers could take itemized deductions for both their state and local income taxes and their state and local sales taxes. The 1986 Tax Reform Act did away with the deduction for sales taxes. The new law brings it back, but only as an option to be taken instead of state and local income taxes. Taxpayers in states with low- or no-income taxes will benefit. Since this option is effective retroactively to the start of 2004, many taxpayers are now scrambling to find sales receipts, especially if they purchased several "big-ticket" items earlier this year. The IRS also will be publishing average sales tax tables soon to be used in lieu of producing receipts for day-to-day purchases. For those taxpayers affected, timing big-ticket purchases and even alternating between taking the sales tax and the state income tax deduction each year may make sense. So far, the optional sales tax deduction is on the books only for 2004 and 2005, but certain members of Congress already are making plans to make it permanent.
- Teachers’ Deduction -- Congress has reinstated the $250 per year "teachers’" deduction for out-of-pocket classroom expenses, retroactively back to January 1, 2004.
- Business Credits and Deductions -- Over a dozen business tax credits and deductions that expired since the end of 2003 have been extended through 2005, including the work opportunity tax credit; welfare-to-work tax credit; research credit; charitable contributions of computer technology and equipment used for educational purposes; expensing of environmental remediation costs; credit for electricity produced from certain renewable resources; suspension of the 100-percent-of-net-income limitation of percentage depletion; credit for qualified electric vehicles; deduction for qualified clean-fuel vehicle property; and for contributions to Archer medical savings accounts.
New Year, New Issues
Many of the provisions in the American Jobs Creation Act start on January 1. Among them, two new tax opportunities, and one giant pitfall, stand out as requiring preparation in 2004 to maximize their benefits in 2005.
- Manufacturers’ Deduction -- Effective January 1, 2005, a significant new deduction arrives for many businesses. The "manufacturers’ deduction" will benefit a considerable number of businesses not traditionally thought of as manufacturers as Congress chose to define "manufacturer" very broadly. In addition to traditional manufacturers, businesses that qualify for the new deduction include construction firms, engineering and architectural firms, film and video production companies, computer software makers, agricultural processors, and even certain service providers may qualify in part. The deduction starts at 3 percent and grows to 9 percent by 2010.
"If you own a business, it may qualify either in whole or in part for the new deduction. You should start planning now to be ready to start maximizing this new tax break on January 1," said Jones.
Many questions remain to be answered by the IRS, so putting your business in a position to change course quickly depending on upcoming rules and regulations is an important step to take as soon as possible.
- S Corporation Reform -- S corporations are one of the fastest growing business entities today, and they are sure to be even more popular under the new law. Instead of 75 shareholders, S corporations will be able to have 100 shareholders. One family can also elect to be treated as a single shareholder. If you’re thinking of starting a business, or converting your business to a different structure, the new rules make S corporations very attractive. All these changes apply to tax years beginning after December 31, 2004.
- Nonqualified Deferred Compensation -- The new law makes important changes to the tax law as it is applied to deferred compensation. Most of these changes start immediately on January 1, 2005. Preparation, starting now, can save major problems next year. If certain operational or design failures occur in a nonqualified deferred compensation plan, the deferred amounts will be included in the affected plan participants’ gross income immediately unless it is still subject to a substantial risk of forfeiture. The plan failures that must be avoided are those having to do with distributions, the acceleration of benefits, and the timing and nature of the election to defer compensation and other elections allowed under the plan.
Traditional Considerations
"Now’s also the time to pay attention to traditional tax considerations" notes Jones. "Year’s end signals your last chance to balance the timing of income and deductions for tax purposes between the current and the upcoming year to your maximum advantage."
Accelerating payment of expenses to generate deductions, deferring receipt of income to defer payment of tax on it up to a full year, carefully timing capital gains to match capital losses and making last-minute contributions to tax-deferred accounts, such as retirement savings and flexible spending accounts, all play roles in a successful year-end tax strategy.
So should testing your current tax status for alternative minimum tax (AMT) liability. Year-end planning can reduce exposure to this "stealth" tax that trapped over one million taxpayers last year, and continues to grow. If you’ve had a change in circumstances during the year—such as marriage or divorce, birth of a child, a death, promotion or job loss, inheritance, or property loss—year-end tax planning takes on extra importance, too.
Traditional considerations include:
- minimizing taxable income to reduce tax on Social Security benefits
- timing taxable gifts to take advantage of the $11,000 annual gift tax exclusion ($22,000 for couples)
- bunching medical expenses and/or miscellaneous itemized deductions to maximize use in connection with adjusted gross income minimums
- deferring or accelerating year-end bonuses
- increasing S corporation or partnership basis to enable deduction of losses
- paying expenses using a credit card to accelerate deductions without the need for immediate cash
- Related items:
- FICA Tax Threshold, Social Security Benefits Will Moderately Increase
- Congress Approves New Tax Cuts Geared Toward Businesses and Individuals
- Congress Extends Individual and Business Tax Cuts; Adds New Tax Relief
- Congress Moves To Make Some Tax Cuts Permanent
- Prepare Now for Next Year's Tax Season
Added to the news on November 22, 2004.
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