Tips for Your 2004 Form 1040

As you gather the data for your individual income tax return, there are several developments for 2004 that merit special attention.

Sales Tax Deduction
For both 2004 and 2005, taxpayers who itemize deductions are permitted to electively claim state and local sales taxes in lieu of any state and local income taxes. The IRS has now prescribed tables based on family size and income that approximate the basic sales tax amount. Generally, if you live in North Carolina, the deduction for state income taxes will provide a greater benefit for you, but if you reside in a state with lower income taxes, you should consider the sales tax deduction.

But the table figure, which we will calculate in the preparation of your return, may be supplemented by specified purchases. We are permitted to add the sales tax paid on motor vehicles, aircrafts, boats, homes, and home building materials. The definition of a motor vehicle includes a motorcycle, motor home, recreational vehicle, and off-road vehicle, and, of course, a car, truck, van, or SUV. Also, the sales tax paid on the lease of a motor vehicle may be added to the table amount.

If you have any of these “add on” purchases during 2004, please be sure to list the item and the sales tax amount in your Form 1040 data.

Charitable Contributions
In well-publicized legislation, Congress provided a one-month extension for charitable contributions for Tsunami relief. Checks issued during January of 2005 to qualified charities for Tsunami relief purposes may be electively deducted in either your 2004 or 2005 tax return. Please separately identify any of these January contributions. Normally, we will deduct these amounts in 2004, but, in some limited circumstances, it may be beneficial to defer the deduction to 2005.

With respect to all charitable contributions, it’s also important to recall the $250 receipt rule. There have been several court cases enforcing rigid adherence to this law. A taxpayer is required to have a receipt from a charity on any single contribution of $250 or more, with that receipt in hand, by the date of filing the tax return. Without the receipt, the IRS can disallow the entire deduction, even if the taxpayer has a canceled check.

As you tabulate your charitable contributions for your 2004 tax return, please be sure that your file records include a receipt for any single contribution of $250 or more. A receipt is not required, however, if each separate donation is under $250, even if the total is larger (e.g., weekly church contributions of $50 are exempt from the receipt rule even though the annual total to the charity exceeds $250).

College Tuition
In the past, taxpayers have been able to claim either a deduction or a tax credit for any post-secondary tuition. Unfortunately, many clients are not able to use these tax benefits, due to phase-out rules that remove the deduction and credits for middle and upper income filers. For 2004, however, Congress has expanded the tuition deduction alternative to allow filers with up to $80,000 of single income or $160,000 of joint income to claim at least a $2,000 tuition deduction.

With your tax return data, be sure to identify any post-secondary tuition paid for you or other family members, even if it is above this income level. There are strategies that allow the college tax credits to offset tax in a student’s return where parental income is too high.

Other 1040 Deductions
Two deductions that were temporarily in the law have been renewed by Congress, and remain available for both 2004 and 2005. Both are allowable on page one of Form 1040, regardless of whether the taxpayer uses the standard or itemized deductions. The first is the $2,000 deduction, allowable for the purchase of a hybrid gas-electric vehicle. Models that qualify include the Ford Escape, Toyota Prius, Honda Insight, and Honda Civic Hybrid.

The second restored deduction is the $250 classroom supply expense for K-12 educators. To qualify, the individual must be employed at least 900 hours during a school year as a teacher, counselor, principal, or aide in a K-12 school.

Dividend Income
Dividends on U.S. stocks, as well as most foreign stock dividends and those passing through mutual funds, continue to qualify for the special 15% federal dividend rate.

Your 1099 from the payor will label those dividends eligible for the 15% rate as “qualifying,” while any remaining portion must be taxed as ordinary income (at rates as high as 35%). So why are some of your dividends ineligible? Here are three possible reasons:

• They are earned on money market funds and actually represent interest income;

• The dividend was received on stock held less than 61 days from the ex-dividend date;

• The shares within the brokerage account were “margined out” in a lending transaction, and a payment in lieu of the actual dividend was received from the brokerage firm.

If this third situation is occurring, consider changing your instructions with the brokerage firm so that you directly receive the actual dividends and qualify for the special 15% tax rate.

BUSINESS DEVELOPMENTS

New Prepaid Deduction Opportunity
Businesses that report for tax purposes on the cash method of accounting enjoy the flexibility of controlling their taxable income by prepaying expenses before their year end. However, this privilege has not been available to those businesses required to report on the accrual method (generally those who deal in goods or inventories and have gross receipts of over $1 million).

New IRS regulations now allow accrual method businesses to electively convert to a method of accounting that allows some year-end prepaid expenses to be immediately deductible. This election must be part of the 2004 tax return (or fiscal year return beginning in 2004). Businesses that make this election are not required to prepay any expenses, but rather simply gain the flexibility to create accelerated deductions in future years that might have greater taxable income.

There are several specific categories of expenditures for which this prepaid method can be adopted. These include insurance, governmental taxes and licenses, and service contracts of a warranty nature. These items can be prepaid for up to 12 months of future benefit, provided the benefit or service that was prepaid does not extend beyond the end of the following tax year.

Example 1: Ace Corp., an accrual method car dealership, files on a December 31 tax year end. Ace has a property insurance policy that has a term of 12 months, requiring a premium due February 1, 2006, for the policy year beginning on that date and ending January 31, 2007. If Ace prepays this premium of $50,000 in December of 2005, it may not claim the deduction under the new rules. While the prepaid item only has 12 months of benefit, it extends beyond the end of the tax year following the year of prepayment (i.e., into 2007, with the prepayment made at the end of 2005).

Example 2: Assume the same facts as in Example 1, except that Ace Corp.’s property insurance policy runs from December 10, 2005, through December 9, 2006. If Ace pays the $50,000 premium in December of 2005, it may deduct the expenditure because the prepaid benefit (i.e., the insurance coverage) does not extend beyond the end of the next tax year.

In addition, accrual businesses may elect to adopt prepaid deductibility for virtually any expenditure for which the service or good is expected to be received within 3½ months following the prepayment. Examples of these items would include prepaid professional fees, postage, advertising, and supplies.

Example 3: Bell Corp., an accrual method retailer, incurs significant postage costs each month to mail its product catalogs and advertising flyers, averaging about $100,000 per month in postage expenditures. Assuming that Bell Corp. properly adopts the 3½-month rule for prepaids such as postage, Bell could prepay and deduct up to $350,000 of prepaid postage at its tax year end. This represents the prepayment of an amount Bell reasonably expects to consume within the 3½-month period following the prepayment.

As we prepare 2004 tax returns for accrual businesses, we will be reviewing the categories of expenditures for which it may be appropriate to adopt this prepaid flexibility. Once adopted, accrual method businesses will be better able to level-out years of greater taxable income through artful use of prepaid expenditures.

New Domestic Production Deduction
Beginning in 2005, there is a new tax deduction for businesses that manufacture, produce, grow, or extract tangible personal property, or construct real estate within the U.S. This deduction starts modestly as 3% of the net income from qualified production, but increases gradually until reaching 9% by 2010.

Manufacturing, construction, farming, and mining activities qualify, but service businesses (other than engineering and architectural services related to construction), and retail and wholesale activities do not qualify. This new deduction will be relatively straightforward for businesses that only engage in qualifying production, as it essentially will be computed on overall net income. However, businesses that engage in a combination of eligible and ineligible activities (e.g., a manufacturer that also wholesales or retails its products) will need to determine the net income attributable to only the qualifying production in order to claim the new subtraction.

The IRS recently released additional guidance on this new deduction. There is now better definition on which activities are considered qualifying production vs. non-qualifying retail or wholesale distribution, and also when a business’ additional work on purchased product will be considered a production activity. For example, if a taxpayer buys a near-finished good from outside the U.S., but the taxpayer’s additional costs within the U.S. to finish the good (labor and allocable overhead) account for 20% or more of the overall cost of the good, the taxpayer is considered to have a qualifying manufacturing activity rather than a disqualified distributing activity.

Please let us know if we can assist your business in identifying and segregating the activities that will qualify for this new deduction.

Deferred Compensation Arrangements
Non-qualified deferred compensation (NQDC) refers to a contractual, one-on-one agreement under which an employee negotiates a deferral of some portion of compensation to a later payout. Typically, a higher earning employee is motivated to use NQDC to defer earnings to post-retirement, when the income can be received at lower tax rates. A key feature of these arrangements is that the employee must be an unsecured creditor of the employer. If the company fails during the deferral period, the employee’s deferred earnings may be lost to other claims against the business.

In late 2004 legislation, Congress enacted a new set of rules to govern all NQDC arrangements. While this new tax legislation was driven by abuses with public company failures such as Enron, these rules can affect even the smallest of employers, and also reach to some independent contractor and partnership deferrals.

The new requirements for NQDC will apply to existing agreements, to the extent any 2005 and subsequent employee earnings are deferred for later payout by the employer. To allow employers and employees adequate time to review and amend their agreements, the IRS recently announced the timeframe for remedial action. We have until December 31, 2005, to amend or terminate any present NQDC agreements, and bring them into compliance with the new law.

If you or your business is a party to any NQDC arrangement, please let us know so that we can assist in the corrective process. In addition to assuring that the agreement meets the new rules to preserve the income tax deferral, there are separate payroll tax considerations and also new W-2 reporting disclosures.

It is very important that NQDC contracts be in conformity by this 12-31-05 deadline. If future earnings are deferred improperly, the employee is taxed on all deferred compensation, plus has a 20% penalty imposed on the amount of this compensation. Also, the employee is charged interest on the tax that was electively deferred.

PERSONAL PLANNING

Tax Efficient Marital Dissolutions
When a divorce occurs, financial anxiety is usually an element. Each party faces the reality of an asset base split in two and usually has diminished income. Certainly in any marital dissolution, strong legal representation is a must, and the attorney leads the process, but effective tax planning is also essential. Taking advantage of all possible tax deductions and income-shifting opportunities can improve the after-tax cash flow of each party and lessen the burden of a difficult financial situation.

The conventional tool to balance post-divorce 1040 income is the use of alimony or separate maintenance. These payments are deductible by the payor and taxable income to the recipient. Conventional wisdom, of course, is to create deductions in the high income return, shifting the income and taxation to the lower bracket of the other party, but economics (equitable division under state law) and taxes are two different things.

The tax law allows us to characterize any portion of an alimony or maintenance payment as non-deductible to the payor and non-taxable to the payee. This flexibility allows us to optimize the tax results, but the proper language must be built into the drafting of the documents.

In the case of a lower income party with custody of children, there are significant tax credits and rebates that can be gained by carefully planning the mix of taxable and non-taxable payments to that person. By targeting certain income thresholds in the payee’s tax return, substantial child tax credit refunds and other tax savings can often be generated.

Recent tax court cases have also imparted a few lessons regarding the requirements for achieving income-shifting status as alimony. Here are a few key points:

• Alimony must be defined as ending at the death of the payee (omission of this limit causes all payments to be non-deductible to the payor);

• Alimony need not be level payments, but a formula prevents excessive “front-loading.” Fortunately, the formula is precise, and it is possible to structure uneven payments that avoid its reach;

• Alimony will be recharacterized as child support (and, therefore, non-deductible) if the payments are adjusted by reference to children.

Property Settlements
At the point of the dissolution, assets are generally split between the spouses. The tax law assures that this division of assets is tax-free, but all assets are not equal. Building A worth $500,000 and Building B worth $500,000 might be markedly different if one has a depreciable cost basis remaining of $400,000 and the other is fully depreciated. In many cases, state marital dissolution statutes do not take these differences of potential capital gain or future depreciation benefit into account.

Similar disparities often exist among security investments and residential properties (a principal residence, for example, qualifies for tax-free sale while other secondary residences do not). Properly quantifying these tax disparities can assure a more accurate equalization of values.

The tax law also allows the transfer of portions of pension and other retirement plan accounts to a former spouse in a divorce. Similarly, IRA accounts can be partially or fully transferred in a divorce, as can valuable unexercised stock options. When the recipient spouse later draws from these retirement plans or exercises the non-qualified stock options, however, there is ordinary income taxation, and if the income arises from stock options, there will also be payroll tax implications. Please let us know if we can assist in navigating through these tax implications.