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2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
2009 Year End Tax Guide
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2009 Year End Tax Guide

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Grant Thornton\'s 2009 Year End Tax Guide discusses recent tax law changes and provides an overview of strategies to help you reduce your tax liability. It will show you how to tax-efficiently invest …

Grant Thornton\'s 2009 Year End Tax Guide discusses recent tax law changes and provides an overview of strategies to help you reduce your tax liability. It will show you how to tax-efficiently invest for education and retirement, and transfer your wealth to family members. For action steps to jump-start the planning process, look for our top 20 tax planning opportunities.

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  1. Year-end tax guide for 2009
  2. Charts 5 Chart 1: Individual income tax rates 18 Chart 6: Tax differences based on business structure 6 Chart 2: Employment tax rates 19 Chart 7: AGI-based limits on charitable contributions 9 Chart 3: AMT rate schedule and exemptions 23 Chart 8: AGI phaseout levels for education tax breaks 11 Chart 4: Top tax rates according to character of income 27 Chart 9: Retirement plan contribution limits 17 Chart 5: Corporate income tax rates 31 Chart 10: Gift and estate tax rates and exemptions Top 20 tax planning opportunities 6 Opportunity 1: Increase withholding instead of 20 Opportunity 10: Give directly from an IRA if you’re estimated tax payments 70½ or older 8 Opportunity 2: Bunch itemized deductions to get 20 Opportunity 11: Give appreciated property to over AGI floors enhance savings 8 Opportunity 3: Take full advantage of above-the-line 24 Opportunity 12: Make payments directly to deductions educational institutions 10 Opportunity 4: Accelerate income to “zero out” the AMT 24 Opportunity 13: Plan around gift taxes with your 529 plan 12 Opportunity 5: Avoid the wash sale rule with a bond swap 28 Opportunity 14: Wait to make your retirement 12 Opportunity 6: Don’t fear the wash sale rule to account withdrawals accelerate gains 30 Opportunity 15: Get kids started with a Roth IRA 14 Opportunity 7: Defer investment interest for a bigger deduction 30 Opportunity 16: Roll yourself over into a Roth IRA 16 Opportunity 8: Consider an 83(b) election on your 32 Opportunity 17: Review and update your estate plan restricted stock 32 Opportunity 18: Exhaust your gift-tax exemption 18 Opportunity 9: Set salary wisely if you’re a corporate 34 Opportunity 19: Use second-to-die life insurance employee-shareholder for extra liquidity 34 Opportunity 20: Zero out your GRAT to save more 1
  3. Year-end tax guide 2009 How much will you pay? Managing your finances and tax burden can feel like juggling Contents and jumping through hoops: You’ve got lots of moving pieces and only two hands. But tax planning has never been more 3 Chapter 1: Tax law changes: What’s new this year important. Drastic changes in the economic environment can 5 Chapter 2: Getting started: Ordinary income taxes, force a shift in tax strategy, especially if your own situation is evolving. rates and rules On top of that, the tax code is only becoming more complex. 7 Chapter 3: Basic strategies: Timing and deductions The economic turmoil of the last year has spurred the passage of more new tax laws. While there are now more ways than ever to 9 Chapter 4: Alternative minimum tax help you reduce your tax liability, taking full advantage of them 11 Chapter 5: Investment income is becoming harder. The outlook for future tax legislation can be even more confusing. You need to think farther ahead, employ 15 Chapter 6: Executive compensation clearer strategies and use every tax break you can. 17 Chapter 7: Business ownership To help you save as much as possible, this Grant Thornton guide discusses recent tax law changes and provides an overview 19 Chapter 8: Charitable giving of strategies to help you reduce your tax liability. It will show 23 Chapter 9: Education savings you how to tax-efficiently invest for education and retirement, and transfer your wealth to family members. For action steps to 27 Chapter 10: Retirement savings jump-start the planning process, look for our top 20 tax planning 31 Chapter 11: Estate planning opportunities. However, this guide simply can’t cover all possible strategies. So be sure to contact us to find out what will work best for you. As of the publication date of this guide, Congress was still considering legislation that could have major tax implications, including a healthcare reform bill and an estate tax reform bill. While the 2009 tax laws won’t likely be affected, new legislation could change your planning strategies. Our National Tax Office tracks tax legislation as it moves through Congress, so visit our website regularly to read updates at www.GrantThornton.com/yearendtaxguide. 2
  4. Chapter 1: Tax law changes: What’s new this year Relief and opportunity Congress and the president enacted a major economic stimulus Did you make any home improvements? bill in 2009, which came just a few months after a number of You may be entitled to a larger tax credit than you think important tax provisions were extended in a financial rescue bill if you made energy-efficient improvements to your home in late 2008. More tax legislation was still possible as this guide this year. The stimulus bill enhanced both the Section 25C went to print, but the stimulus bill alone included $326 billion home improvement tax credit and the Section 25D residential in new tax cuts. Virtually no revenue raisers were included. energy-efficient property tax credit. Lawmakers decided that with the economy in trouble, it was Section 25C provides a credit for installing energy-saving not the right time to apply the kinds of tax increases that have property, such as insulation, energy-efficient windows and roofs, been used to pay for legislation in past years. and highly efficient air conditioners, furnaces and water heaters. Most of the tax provisions from the new tax bills are In 2008, the credit rate was 10 percent and had a lifetime limit of designed either to stimulate economic activity or provide relief $500. For 2009, the credit rate has been increased to 30 percent to taxpayers that have suffered from the downturn. Many are with an additional $1,500 added to the lifetime limit. geared toward individuals, and these will provide scores of Section 25D provides a 30-percent personal tax credit taxpayers with fresh opportunities for tax savings. for energy-efficient property, such as solar water heaters, geothermal heat pumps and fuel cells. Previously, this credit Take a new look at education incentives was generally capped between $500 and $4,000 depending on You may need to reexamine education credits this year, even the property. The stimulus bill eliminates the credit caps for if you assumed you earn too much to qualify. The stimulus bill solar, geothermal and wind property and allows the use of enhanced the Hope Scholarship credit for 2009 and 2010 and subsidized energy financing. renamed it the American Opportunity credit. The credit is now more generous, equal to 100 percent of the first $2,000 of tuition Did you buy a car this year? and 25 percent of the next $2,000, for a total credit of up to The “cash for clunkers” program stole all the press this year, $2,500. It is also 40 percent refundable. but many car-buyers who didn’t have a clunker to trade in But most importantly, it is allowed against the alternative will still get a substantial deduction for a new car purchase. minimum tax (AMT) and phases out at a much higher income The stimulus bill created an above-the-line deduction for state level. For 2009 and 2010, the credit will phase out between and local sales tax on new car purchases made between Feb. 17 adjusted gross incomes of $80,000 and $90,000 for single and the end of the year. filers and $160,000 and $180,000 for married couples filing The deduction is allowed for taxes on the first $49,500 of jointly. (See page 23 for a full discussion of tax planning for the car’s price, and the phaseout range is unusually high for this education expenses.) type of targeted benefit. The deduction phases out between the adjusted gross income (AGI) levels of $125,000 and $135,000 for single individuals and $250,000 and $260,000 for joint filers. Above-the-line deductions are especially valuable because they reduce AGI (see more on this strategy on page 8), but this deduction is not available if you elect to claim state and local taxes as an itemized deduction. 3
  5. Would you consider investing in a small business? against taxes paid in prior years. Normally, the net operating Qualified small business (QSP) stock has become an even more loss carryback period is only two years, but businesses that attractive investment. The stimulus bill increased the exclusion meet all the restrictions in the bill can elect a carryback period on the gain from the sale of QSP stock from 50 percent to of three, four or five years. 75 percent for stock bought after Feb. 17, 2009, and before The stimulus bill also will allow taxpayers to defer Jan. 1, 2011. This stock is taxed at a long-term capital gains cancellation of debt (COD) income incurred in 2009 and rate of 28 percent, so the increased exclusion drives the effective 2010. COD income arises from virtually any “forgiveness” rate down from 14 percent to 7 percent. Investments in qualified of debt, whether it comes from retiring a debt at a discount, small business stock also come with several other tax benefits. refinancing an existing debt, exchanging an old debt for a new (See page 12 for more details.) one or any other modification. The deferred COD income will be recognized ratably over the five years beginning in 2014. Are you required to make distributions from your The stimulus bill also lowered withholding and estimated retirement plan? tax requirements for certain taxpayers with AGIs under Normally, taxpayers must begin making required minimum $500,000 who earn at least half of their income from a small distributions (RMDs) from tax-preferred retirement savings trade or business. Qualifying taxpayers will only need to pay accounts such as IRAs, 401(k)s, 403(b) plans and some 457(b) the equivalent of 90 percent of their 2008 tax throughout 2009 plans once they reach age 70½. These distributions are calculated to avoid 2009 underpayment penalties, rather than 100 percent using your account balance and life expectancy table and or 110 percent. (For a more detailed discussion on payment generally must be taken each year by Dec. 31. If not, you can requirements, see page 6.) be charged a 50-percent penalty on the amount that should have been withdrawn. Be aware of what Congress hasn’t done yet Lawmakers late last year were concerned that the As this guide went to print, Congress was still considering distribution requirements were unfair to taxpayers whose several bills that could have major tax implications. Most retirement accounts were battered by the downturn, so they significantly, a healthcare reform bill, if enacted, is likely enacted a provision to waive all RMDs for 2009. The normal to carry a large tax component. RMD rules are suspended completely, so no taxpayer has to Congress was also planning to consider a bill to reform the make an RMD for 2009. This includes taxpayers reaching 70½ estate tax before it is scheduled to disappear for one year in 2010. during calendar-year 2009. The suspension is permanent. You (For more information on the estate tax, see page 31.) That bill will not have to increase distributions in a later year to make could also extend many popular tax provisions that remain in up for 2009. (See Tax planning opportunity 14 for strategies on place for 2009, but are scheduled to expire in 2010. While these dealing with RMDs.) changes won’t likely affect the tax laws in 2009, they could change planning strategies right away. Are you a business owner? Call Grant Thornton to find out the latest status of Business owners should be aware of several additional tax legislation and to discuss any tax-saving opportunities opportunities provided by the stimulus bill. The bill allows arising from provisions enacted this year. qualifying small businesses with under $15 million in annual gross receipts to carry 2008 losses farther back to receive refunds 4
  6. Chapter 2: Getting started: Ordinary income taxes, rates and rules Our tax system Our income tax system seems straightforward at first glance. In 2009, the personal exemption of $3,650 that taxpayers Individuals are taxed according to their income, with rates receive for themselves, their spouses and their dependents phases increasing as income goes up. So, the more you make, the out by $24.33 for every $2,500 (or fraction thereof) of adjusted higher percentage of tax you’re expected to pay. These gross income (AGI) above a designated high-income threshold. increasing rates are often referred to as “tax brackets.” The This threshold in 2009 is: top rate that applies to you, or your tax bracket, is usually • $166,800 for single filers, considered your marginal tax rate. It’s the rate you will pay • $250,200 for joint filers, on an additional dollar of income. • $208,500 for heads of household, and For 2009, the ordinary income tax brackets range from • $125,100 for married couples filing separately. 10 percent to 35 percent. (See chart 1 for the full schedule.) Ordinary income includes things such as salary and bonuses, In 2009, each personal exemption can be reduced to no self-employment and business income, interest, retirement plan lower than $2,433. distributions and more. Looking beyond the tax brackets Unfortunately, the tax brackets for ordinary income don’t tell the whole story. Your effective marginal rate may be much different than the actual rate in your tax bracket. For one, not everything is ordinary income. Different types of income are taxed in different ways. (See page 11 for information on investment income.) But more importantly, hidden taxes that kick in at higher income levels when you reach the top tax brackets can drive your marginal tax rate higher. Many tax credits and deductions phase out as your income increases, meaning an extra dollar of income actually increases your tax liability more than the top tax rate. Two of the most costly phaseouts apply to your personal exemptions and itemized deductions. Chart 1: 2009 individual income tax brackets Married filing jointly Tax rate Single Head of household Married filing separately or surviving spouse 10% $0 – $8,350 $0 – $11,950 $0 – $16,700 $0 – $8,350 15% $8,351 – $33,950 $11,951 – $45,500 $16,701 – $67,900 $8,351 – $33,950 25% $33,951 – $82,250 $45,501 – $117,450 $67,901 – $137,050 $33,951 – $68,525 28% $82,251 – $171,550 $117,451 – $190,200 $137,051 – $208,850 $68,526 – $104,425 33% $171,551 – $372,950 $190,201 – $372,950 $208,851 – $372,950 $104,426 – $186,475 35% Over $372,950 Over $372,950 Over $372,950 Over $186,475 5
  7. The phaseout for itemized deductions operates a little Chart 2: Employment taxes differently. Some deductions — such as medical expenses, Social Security Medicare Total tax investment interest, casualty losses and certain contributions to disaster relief — are not included in the phaseout. But 2009 income limit $106,800 no limit NA Employee rate 6.2% 1.45% 7.65% many of the most popular and valuable deductions — such Employer rate 6.2% 1.45% 7.65% as mortgage interest and employee business expenses — are Self-employed rate 12.4% 2.90% 15.30% affected. In 2009, the affected deductions are reduced by an amount equal to one percent of any AGI that exceeds $166,800 an above-the-line deduction for 50 percent of the total tax. ($83,400 for married couples filing separately) up to a maximum There are also special employment tax considerations if you’re reduction of 26.67 percent. a business owner who works in the business. (See Tax planning The effects of the phaseouts of both itemized deductions opportunity 9.) and personal exemptions have been shrinking gradually thanks to a 2001 tax bill. In 2010, both are scheduled to disappear Taxes are due year round completely for one year. But in 2011, they are scheduled to Although you don’t file your return until after the end of come back at triple their 2009 rates. If that occurs, beginning the year, it’s important to remember that you must pay in 2011 your personal exemptions can be eliminated completely tax throughout the year with estimated tax payments or and the applicable itemized deductions can be reduced by up withholding. You will be penalized if you haven’t paid enough. to 80 percent. If your AGI was over $150,000 in 2008, you can generally It’s worth noting that both of these phaseouts are tied to avoid penalties by paying at least 90 percent of your 2009 AGI, as are nearly all of the tax-benefit phaseouts in the code tax liability or 110 percent of your 2008 liability through that apply to individuals. That’s why above-the-line deductions withholding and estimated taxes (taxpayers under $150,000 are so valuable. They reduce AGI. Most other deductions and need only pay 100 percent of 2008 liability). Additionally, the credits only reduce taxable income or tax, itself, without affecting stimulus bill enacted in February 2009 allows certain taxpayers AGI. (See Tax planning opportunity 3 for information on taking with a 2008 AGI of under $500,000, and at least half their income full advantage of above-the-line deductions.) from a small business, to prepay an amount equal to just 90 Phaseouts of tax benefits aren’t the only things you need to percent of their 2008 liability. worry about. Many high-income taxpayers could also face the If your income is often irregular due to bonuses, investments alternative minimum tax (see page 9 on the AMT), and anyone or seasonal income, consider the annualized income installment with earned income will have to pay employment taxes. method. This method allows you to estimate the tax due based on income, gains, losses and deductions through each estimated Employment taxes take a bite tax period. If you’ve found you’ve underpaid, try and have the Employment taxes are made up of Social Security and Medicare shortfall withheld from your salary or bonus. (See Tax planning taxes and apply to earned income. Social Security taxes are opportunity 1.) capped, but you must pay Medicare tax on all of your earned You also want to avoid early withdrawals from tax- income. (See chart 2 for the current employment tax rates and advantaged retirement plans, such as 401(k) accounts and Social Security tax ceiling.) individual retirement accounts (IRAs). Distributions generally If you are employed and your earned income consists of must be made after reaching the age of 59½ to avoid penalties. salaries and bonus, your employer will withhold your share Distributions from these plans are treated as ordinary income, of these taxes and pay them directly to the government. If you and you’ll pay an extra 10-percent penalty on any premature are self-employed, you must pay both the employee and the withdrawals. This can raise your effective federal tax rate to employer portions of employment tax, though you can take as high as 45 percent on the income. Tax planning opportunities 1 Make up any estimated tax shortfall with increased withholding, not estimated tax payments If you’re in danger of being penalized for not paying enough tax throughout the year, try to make up the shortfall through increased withholding on your salary or bonuses. Paying the shortfall through an increase in your last quarterly estimated tax payment can still leave you exposed to penalties for underpayments in previous quarters. But withholding is considered to have been paid ratably throughout the year. So a big bump in withholding on high year-end wages can save you in penalties when a similar increase in an estimated tax payment might not. 6
  8. Chapter 3: Basic strategies: Timing and deductions Timing income and expenses Why pay tax now when you can pay tomorrow? Deferring tax There are many reasons to believe that existing tax is a traditional cornerstone of good tax planning. Generally this benefits scheduled to expire in 2011 will be extended, at least means you want to accelerate deductions into the current year for taxpayers with incomes below $250,000 (for a married couple and defer income into next year. So it’s important to review your filing a joint return). President Obama has proposed an extension income and deductible expenses well before Dec. 31. You need of current tax benefits for these taxpayers, and Republican to take action before the new year to affect your 2009 return. leaders have indicated they support an even broader extension. However, deferring income and accelerating deductions Legislation addressing this issue may not be considered until may not always make sense. If you are going to be subject to 2010. So call Grant Thornton to discuss the latest legislative the alternative minimum tax (AMT) in one year and not another, developments and to find out how you, personally, may want it can affect your timing strategy. (See page 9 for more on coping to approach timing. with the AMT). More importantly, if you believe that tax rates Whether it eventually makes more sense for you to defer are going up, you may feel it is beneficial to do the opposite. In or accelerate your taxes, there are many items with which you that case, you want to realize more income now when rates are may be able to control timing: low and save your deductions for later when rates are higher. Timing your income and expenses properly can clearly Income reduce your tax liability. Currently, many tax benefits are • Bonuses scheduled to remain in place and even improve from 2009 • Consulting income to 2010, but then disappear in 2011. Taxpayers may want to • Other self-employment income consider deferring tax into 2010 and then accelerating income • Real estate sales ahead of a potential tax increase in 2011. • Other property sales But be cautious. Legislative action is likely to make a big • Retirement plan distributions difference in this area, as will your personal situation. Income acceleration can be a powerful strategy, but it should only Expenses be employed if you are comfortable with your own political • State and local income taxes analysis and are prepared to accept the consequences if you • Real estate taxes are wrong. • Mortgage interest • Margin interest • Charitable contributions It’s important to remember that prepaid expenses can be deducted only in the year they apply. So you can prepay 2009 state income taxes to receive a 2009 deduction even if the taxes aren’t due until 2010. But you can’t prepay state taxes on your 2010 income and deduct the payment on your 2009 return. But don’t forget the AMT. If you are going to be subject to the AMT in both 2009 and 2010, it won’t matter when you pay your state income tax, because it will not reduce your AMT liability in either year. 7
  9. Timing deductions can make a big difference Keep in mind that medical expenses aren’t deductible if Timing can often have the biggest impact on your itemized they are reimbursable through insurance or paid through a deductions. How and when you take these deductions is pretax Health Savings Account or Flexible Spending Account. important because many itemized deductions have AGI floors. The AMT can also complicate this strategy. For AMT purposes, For instance, miscellaneous expenses are deductible only to only medical expenses in excess of 10 percent of your AGI the extent they exceed two percent of your AGI, and medical are deductible. expenses are only deductible to the extent they exceed 7.5 You also want to take full advantage of above-the-line percent of your AGI. Bunching these deductions into a single deductions to the extent possible. They are not subject to the year may allow you to exceed these floors and save more. AGI floors that hamper many itemized deductions. They even (See Tax planning opportunity 2 to find out how to make reduce AGI, which provides a number of tax benefits. (See Tax this strategy work.) planning opportunity 3.) Tax planning opportunities 2 Bunch itemized deductions to get over AGI floors Bunching deductible expenses into a single year can help you get over AGI floors for itemized deductions, such as the two-percent AGI floor for miscellaneous expenses and the 7.5-percent floor for medical expenses. Miscellaneous expenses you may be able to accelerate and pay now include: • deductible investment expenses, such as investment advisory fees, custodial fees, safe deposit box rentals and investment publications; • professional fees, such as tax planning and preparation, accounting and certain legal fees; and • unreimbursed employee business expenses, such as travel, meals, entertainment, vehicle costs and publications — all exclusive of personal use. Bunching medical expenses is often easier than bunching miscellaneous itemized deductions. Consider scheduling your non-urgent medical procedures and other controllable expenses into one year to take advantage of the deductions. Deductible medical expenses include: • health insurance premiums, • prescription drugs, and • medical and dental costs and services. In extreme cases, and assuming you are not subject to AMT, it may even be possible to claim a standard deduction in one year, while bunching two years’ worth of itemized deductions in another. 3 Take full advantage of above-the-line deductions Above-the-line deductions are especially valuable. They aren’t reduced by AGI floors like many itemized deductions and have the enormous benefit of actually reducing AGI. Nearly all of the tax benefits that phase out at high income levels are tied to AGI. The list includes personal exemptions and itemized deductions, education incentives, charitable giving deductions, the alternative minimum tax exemption, some retirement accounts and real estate loss deductions. Above-the-line deductions that reduce AGI could increase your chances of enjoying other tax preferences. Common above-the-line deductions include traditional Individual Retirement Account (IRA) and Health Savings Account (HSA) contributions, moving expenses, self-employed health insurance costs and alimony payments. Take full advantage of these deductions by contributing as much as possible to retirement vehicles that provide them, such as IRAs and SEP IRAs. Don’t skimp on HSA contributions either. When possible, give the maximum amount allowed. And don’t forget that if you’re self-employed, the cost of the high deductible health plan tied to your HSA is also an above-the-line deduction. 8
  10. Chapter 4: Alternative minimum tax Don’t let the AMT take you by surprise The alternative minimum tax (AMT) is perhaps the most The AMT includes a large exemption, but this exemption unpleasant surprise lurking in the tax code. It was originally phases out at high-income levels. And unlike the regular tax conceived to ensure all taxpayers paid at least some tax, but system, the AMT isn’t adjusted regularly for inflation. Instead, has long since outgrown its intended use. Congress must legislate any adjustments. Congress has been The AMT is essentially a separate tax system with its own doing this on an approximately year-by-year basis for several set of rules. How do you know if you will be subjected to the years, and they have already made an adjustment for 2009. AMT? Each year you must calculate your tax liability under the But it’s important to remember that so far, Congress has only regular income tax system and the AMT, and then pay the increased the exemption amount with each year’s “patch,” higher amount. while the phaseout of the exemption and the AMT tax The AMT is made up of two tax brackets, with a top rate brackets remain unchanged. (See chart 3.) of 28 percent. Many deductions and credits are not allowed under the AMT, so taxpayers with substantial deductions that are reduced or not allowed under the AMT are the ones stuck paying. Common AMT triggers include: • state and local income and sales taxes, especially in high-tax states; • real estate or personal property taxes; • investment advisory fees; • employee business expenses; • incentive stock options; • interest on a home equity loan not used to build or improve your residence; • tax-exempt interest on certain private activity bonds; and • accelerated depreciation adjustments and related gain or loss differences on disposition. Chart 3: 2009 individual AMT rate schedule and exemptions AMT brackets AMT exemption 26% tax rate 28% tax rate Exemption Phaseout Single or head of household $0 – $175,000 Over $175,000 $46,700 $112,500 – $299,300 Married filing jointly $0 – $175,000 Over $175,000 $69,950 $150,000 – $429,800 Married filing separately $0 – $87,500 Over $87,500 $34,975 $75,000 – $214,900 9
  11. Proper planning can help you mitigate, or even If you have to pay the AMT, you may be able to take eliminate, the impact of the AMT. The first step is to work advantage of an AMT credit that has become more generous with Grant Thornton to determine whether you could be recently. You can qualify for the AMT credit by paying AMT subject to the AMT this year or in the future. In years you’ll on timing items like depreciation adjustments, passive activity be subject to the AMT, you want to defer deductions that adjustments and incentive stock options. The credit can be taken are erased by the AMT and possibly accelerate income to against regular tax in future years, as it is meant to account for take advantage of the lower AMT rate. (See Tax planning timing differences that reverse in the future. opportunity 4 on zeroing out your AMT.) The AMT credit may only provide partial relief, but just got Capital gains and qualified dividends deserve special a little more generous. A tax bill enacted late in 2008 now allows consideration for the AMT. They are taxed at the same you to use AMT credits at least four years old in 50-percent 15-percent rate either under the AMT or regular tax increments over a period of two years, even in years when the structure, but the additional income they generate can AMT continues to apply. The AGI phaseout of this special tax reduce your AMT exemption and result in a higher break has also been removed. AMT bill. So consider your AMT implications before selling any stock that could generate a large gain. Tax planning opportunities 4 Accelerate income to “zero out” the AMT You have to pay the AMT when it results in more tax than your regular income tax calculation, typically because the AMT has taken away key deductions. The silver lining is that the top AMT tax rate is only 28 percent. So you can “zero out” the AMT by accelerating income into the AMT year until the tax you calculate for regular tax and AMT are the same. Although you will have paid tax sooner, you will have paid at an effective tax rate of only 26 percent or 28 percent on the accelerated income, which is less than the top rate of 35 percent that is paid in a year you’re not subject to the AMT. If the income you accelerate would otherwise be taxed in a future year with a potential top rate of 39.6 percent, the savings could be even greater. But be careful. If the additional income falls in the AMT exemption phaseout range, the effective rate may be a higher 31.5 percent. The additional income may also reduce itemized deductions and exemptions (as discussed on page 6), so you need to consider the overall tax impact. 10
  12. Chapter 5: Investment income Making tax-smart investment decisions Not all income is created equal. The character of income Chart 4: Top tax rates of different types of income under current code determines its tax rate and treatment. Investment income 2009–10 2011+ alone comes in a variety of forms. Income such as dividends and interest arises from holding investments, while capital Ordinary income 35% 39.6% Qualifying dividends 15% 39.6% gains income results from the sale of investments. Short-term capital gains 35% 39.6% Investment income is often treated more favorably than Long-term capital gains 15% 20% ordinary income, but the rules are complex. Long-term capital Key exceptions to regular gains and qualifying dividends can be taxed as low as 15 percent, capital gains rates 2009–10 2011+ Qualified small business stock while nonqualified dividends, interest and short-term capital held more than 5 years1 7%2 14% gains are taxed at ordinary income tax rates as high as 35 percent. Gain that would be taxed in the 10% or 15% Special rates also apply to specific types of capital gains and other brackets based on the taxpayer’s income level3 0% 10% investments, such as mutual funds and passive activities. But 1 The effective rate for qualified small business stock is based on 28% rate and the these rates aren’t scheduled to last forever. Unless Congress acts, applicable gain exclusion. rates will increase on all types of income in 2011. (See chart 4.) 2 The 7% effective rate applies for stock acquired after Feb. 17, 2009, and before Jan. 1, 2011. Otherwise qualified small business stock will have 14% effective rate. The various rules and rates on investment income offer 3 The 10% bracket is scheduled to disappear in 2011. many opportunities for you to minimize your tax burden. Understanding the tax costs of various types of investment Capital gains and losses income can also help you make tax smart decisions. But To benefit from long-term capital gains treatment, you must remember that tax planning is just one part of investing. hold a capital asset for more than 12 months before it is sold. You must also consider your risk tolerance, desired asset Selling an asset you’ve held for 12 months or less results in less allocation and whether an investment makes sense for your favorable short-term capital gains treatment. Several specific financial and personal situation. types of assets have special, higher capital gains rates, and taxpayers in the bottom two tax brackets enjoy a zero rate on their capital gains and dividends in 2009 and 2010. Your total capital gain or loss for tax purposes is generally calculated by netting all the capital gains and losses throughout the year. You can offset both short-term and long-term gains with either short-term or long-term losses. Taxpayers facing a large capital gains tax bill often find it beneficial to look for unrealized losses in their portfolio so they can sell the assets to offset their gains. But keep the wash sale rule in mind. You can’t use the loss if you buy the same — or a substantially identical — security within 30 days before or after you sell the security that creates the loss. 11
  13. There are ways to mitigate the wash sale rule. You may If you have adult children in these tax brackets, consider be able to buy securities of a different company in the same giving them dividend-producing stock or long-term appreciated industry or shares in a mutual fund that holds securities much stock. They can sell the stock for gains or hold the stock for like the ones you sold. Alternatively, consider a bond swap. dividends without owing any taxes. (See Tax planning opportunity 5 on bond swaps.) Keep in mind there could be gift tax and estate planning It may prove unwise to try and offset your capital gains consequences. (See page 32 to learn about gifting strategies.) at all. Up to $3,000 in net capital loss can be claimed against Gifts to children up to the age of 23 can also be subject to the ordinary income (with a top rate of 35 percent in 2009 and “kiddie tax.” (See page 26 for more information.) 2010), and the rest can be carried forward to offset future short-term loss or ordinary income. More importantly, long- Mutual fund pitfalls term capital gains rates in 2009 and 2010 are a low 15 percent, Investing in mutual funds is an easy way to diversify your but are scheduled to increase to 20 percent in 2011. It may portfolio, but comes with tax pitfalls. Earnings on mutual actually be time to consider selling assets with unrealized funds are typically reinvested. Unless you (or your broker or gains now to take advantage of the current low rates. (See investment advisor) keep track of these additions to your basis, Tax planning opportunity 6 for more on recognizing gains.) and you designate which shares you are selling, you may report Be careful, however. The 15-percent rate could be extended more gain than required when you sell the fund. beyond 2010, at least to the extent the net capital gain does not It is often a good idea to avoid buying shares in an equity push taxable income above $250,000 for a married couple filing mutual fund right before it declares a large capital gains a joint return. (See page 7 for more on the legislative prospects distribution, typically at year-end. If you own the shares on of tax increases.) the record date of the distribution, you’ll be taxed on the full Regardless of whether you want to accelerate or mitigate distribution amount even though it may include significant gains a net capital gain, the tax consequences of a sale can come as a realized by the fund before you owned the shares. Worse yet, surprise, unless you remember the following rules: you’ll end up paying taxes on those gains in the current year — • If you bought the same security at different times and even if you reinvest the distribution in the fund and regardless prices, you should specifically identify in writing which of whether your position in the fund has appreciated. shares are to be sold by the broker before the sale. Selling the shares with the highest basis will reduce your gain or Small business stock comes with tax rewards increase your losses. Buying stock in a qualified small business (QSB) comes • For tax purposes, the trade date and not the settlement date with several tax benefits, assuming you comply with specific of publicly traded securities determines the year in which requirements and limitations. If you sell QSB stock at a loss, you you recognize the gain or loss. can treat up to $50,000 ($100,000, if married filing jointly) as an ordinary loss, regardless of your holding period. This means you Use zero capital gains rate to benefit children can use it to offset ordinary income taxed at a 35-percent rate, Taxpayers in the bottom two tax brackets pay no taxes on such as salary and interest. long-term capital gains and qualifying dividends in 2009 and You can also roll over QSB stock without realizing gain. 2010. If income from these items would be in the 10-percent If you buy QSB stock with the proceeds of a sale of QSB stock or 15-percent bracket based on a taxpayer’s income, than the within 60 days, you can defer the tax on your gain until you tax rate is zero. dispose of the new stock. The new stock’s holding period for long-term capital gains treatment includes the holding period of the stock you sold. Tax planning opportunities 5 Avoid the wash sale rule with a bond swap Bond swaps are a way to maintain your investment position while recognizing a loss. With a bond swap, you sell a bond, take a capital loss and then immediately buy another bond of similar quality from a different issuer. You’ll avoid the wash sale rule because the bonds are not considered substantially identical. 6 Don’t fear the wash sale rule to accelerate gains Remember, there is no wash sale rule for gains, only losses. You can recognize gains anytime by selling your stock and repurchasing it immediately. This may be helpful if you have a large net capital loss you don’t want to carry forward or want to take advantage of today’s low rates. Waiting until after 2010 to pay tax on unrealized gains could result in a larger tax bill, if rates do indeed go up. 12
  14. Most importantly, you may only have to pay an effective It’s also important to reallocate your retirement plan assets rate as low as seven percent on long-term gain of QSB stock. periodically. For example, the allocation you set up for your The gain is normally taxed at a 28-percent rate, but a 50-percent 401(k) plan 10 years ago may not be appropriate now that you’re exclusion allows for an effective tax rate of 14 percent. However, closer to retirement. (See page 27 on saving for retirement.) the stimulus bill enacted in February 2009 allows taxpayers to exclude 75 percent of the gain from qualifying stock bought after Planning for passive losses Feb. 17, 2009, and before Jan. 1, 2011, for an effective tax rate of There are special rules for income and losses from a passive just seven percent. activity. Investments in a trade or business in which you don’t materially participate are passive activities. You can prove your Rethinking dividend tax treatment material participation by participating in the trade or business for The tax treatment of income-producing assets can affect more than 500 hours during the year or by demonstrating that investment strategy. Qualifying dividends generally are taxed your involvement represents substantially all of the participation at the reduced rate of 15 percent, while interest income is taxed in the activity. at ordinary-income rates of up to 35 percent. So, dividend- The designation of a passive activity is important, because paying stocks may be more attractive from a tax perspective passive activity losses are generally deductible only against than investments like CDs and bonds. But there are exceptions. income from other passive activities. You can carry forward Some dividends are subject to ordinary-income rates. disallowed losses to the following year, subject to the same These may include certain dividends from: limitations. There are options for turning passive losses into • money market mutual funds, tax-saving opportunities. • mutual savings banks, You can increase your activity to more than 500 hours. • real estate investment trusts (REITs), Alternatively, you can limit your activities in another business • foreign investments, to less than 500 hours or invest in another income-producing • regulated investment companies, and business that will be passive to you. Either way, the other • stocks, to the extent the dividends are offset by margin debt. businesses can give passive income to offset your passive losses. Finally, consider disposing of the activity to deduct Some bond interest is exempt from income tax. Interest on all the losses. The disposition rules can be complex, so consult U.S. government bonds is taxable on your federal return, but with a Grant Thornton tax advisor. it’s generally exempt on your state and local returns. Interest on Rental activity has its own set of passive loss rules. Losses state and local government bonds is excludible on your federal from real estate activities are passive by definition unless you’re return. If the state or local bonds were issued in your home state, a real estate professional. If you’re a real estate professional, you interest also may be excludible on your state return. Although can deduct real estate losses in full, but you must perform more state and municipal bonds usually pay a lower interest rate, than half of your personal services in real property trades and their rate of return may be higher than the after-tax rate of businesses annually and spend more than 750 hours in these return for a taxable investment. services during the year. If you actively participate in a rental real estate activity but Review portfolio for tax balance you aren’t a real estate professional, you may be able to deduct You should consider which investments to hold inside and up to $25,000 of real estate losses each year. This deduction is outside your retirement accounts. If you hold taxable bonds subject to a phaseout beginning when adjusted gross income to generate income and diversify your overall portfolio, (AGI) reaches $100,000 ($50,000 for married taxpayers filing consider holding them in a retirement account where there separately). won’t be a current tax cost. Bonds with original issue discount (OID) build up “interest” Leveraging investment expenses as they rise toward maturity. You’re generally considered to You are allowed to deduct expenses used to generate investment earn a portion of that interest annually — even though the bonds income unless they are related to tax-exempt income. Investment don’t pay you this interest annually — and you must pay tax on expenses can include investment firm fees, research costs, it. They also may be best suited for retirement accounts. security costs such as a safe deposit box, and most significantly, Try to own dividend-paying stocks that qualify for the investment interest. Apart from investment interest, these 15-percent tax rate outside of retirement plans so you’ll benefit expenses are considered miscellaneous itemized deductions from the lower rate. and are deductible only to the extent they exceed two percent of your AGI. 13
  15. Investment interest is interest on debt used to buy assets Your home as an investment held for investment, such as margin debt used to buy securities. There are many home-related tax breaks. Whether you own Payments a short seller makes to the stock lender in lieu of one home or several, it’s important to take advantage of your dividends may be deductible as an investment interest expense. deductions and plan for any gains or rental income. Your investment interest deduction is limited to your net Property tax is generally deductible as an itemized deduction. investment income, which generally includes taxable interest, Even if you don’t itemize, a provision scheduled to expire in dividends and short-term capital gains. Any disallowed 2010 allows you an above-the-line deduction of up to $500 interest is carried forward for a deduction in a later year, ($1,000 if filing jointly) on personal property taxes. But which may provide a beneficial opportunity. (See Tax remember, property tax isn’t deductible for alternative planning opportunity 7.) minimum tax (AMT) purposes. If you don’t want to carry forward investment interest You can also deduct mortgage interest and points on your expense, you can elect to treat net long-term capital gain or principal residence and a second home. The deduction is good qualified dividends as investment income in order to deduct for interest on up to $1 million in total mortgage debt used to more of your investment interest, but it will be taxed at purchase, build or improve your homes. In addition, you can ordinary-income rates. Remember that interest on debt used to deduct interest on a home equity loan with a balance up to buy securities that pay tax-exempt income, such as municipal $100,000. Consumer interest isn’t deductible, so consider using bonds, isn’t deductible. Also keep in mind that passive interest home equity debt (up to the $100,000 limit) to pay off credit expense — interest on debt incurred to fund passive activity cards or auto loans. But remember, home equity debt is not expenditures — becomes part of your overall passive activity deductible for the AMT unless it’s used for home improvements. income or loss, subject to limitations. When you sell your home, you can generally exclude up to $250,000 ($500,000 for joint filers) of gain if you’ve used it as Be wary of deferral strategies your principal residence for two of the preceding five years. But Deferring taxes is normally a large part of good planning. under a recently enacted provision, you will have to include gain But with capital gains rates scheduled to go up, the benefits of on a pro-rata basis for any years after 2009 that the home was deferring income may be outweighed by the burden of higher not used as your principal residence. Maintain thorough records tax rates in the future. If you believe your rates will go up, to support an accurate tax basis, and remember, you can only consider avoiding or fine tuning strategies to defer gain, such deduct losses attributable exclusively for business or rental use as an installment sale or like-kind exchange. (subject to various limitations). Like-kind exchanges under Section 1031 allow you to The rules for rental income are complicated, but you can rent exchange real estate without incurring capital gains tax. Under out all or a portion of your primary residence and second home a like-kind exchange, you defer paying tax on the gain until you for up to 14 days without having to report the income. No rental sell your replacement property. expenses will be deductible. If you rent out your property for An installment sale allows you to defer capital gains on most 15 days or more, you have to report the income, but can also assets other than publicly traded securities by spreading gain claim all or a portion of your rental expenses — such as utilities, over several years as you receive the proceeds. If you’re engaging repairs, insurance and depreciation. Any deductible expenses in in an installment sale, consider creating a future exit strategy. excess of rental income can be carried forward. You may want to build in the ability to pledge the installment If the home is classified as a rental for tax purposes, you can obligation. Deferred income on most installment sales made deduct interest that’s attributable to its business use but not any after 1987 can be accelerated by pledging the installment note interest attributable to personal use. for a loan. The proceeds of the loan are treated as a payment on the installment note itself. If legislation is enacted that increases the capital gains rate in the future (or makes clear the scheduled increase will occur), this technique can essentially accelerate the proceeds of the installment sale. Tax planning opportunities 7 Defer investment interest for a bigger deduction Unused investment interest expense can be carried forward indefinitely and may be usable in later years. It could make sense to carry forward your unused investment interest until after 2010, when tax rates are scheduled to go up and the 15-percent rate on long-term capital gains and dividends is scheduled to disappear. The deduction could save you more at that time if rates do go up. 14
  16. Chapter 6: Executive compensation Thinking through your options You may be compensated with more than just salary, fringe ISOs have several potential tax benefits benefits and bonuses. Many people are rewarded with incentives • There is no tax when the options are granted. like stock options, deferred compensation plans and restricted • Long-term capital gains treatment is available if stock. These benefits come with complicated tax consequences, the stock is held for one year after exercise and giving you perils to avoid and opportunities to consider. two years after the grant date. • There is no tax when the options are exercised Benefitting from incentive stock options as long as the stock is held long enough to qualify Stock options remain one of the most popular types of incentive for long-term capital gains treatment. compensation, and incentive stock options (ISOs) deserve special attention in your tax planning. If your options qualify as ISOs, However, there is potential alternative minimum tax (AMT) you may be able to take advantage of favorable tax treatment. liability when the options are exercised. The difference between ISOs give you the option of buying company stock in the the fair market value of the stock at the time of exercise and the future. The price must be set when the options are granted and exercise price is included as income for AMT purposes. The must be at least the fair market value of the stock at that time. liability on this bargain element is a problem because exercising Therefore, the stock must rise before the ISOs have any value. the option alone doesn’t generate any cash to pay the tax. If the If it does, you have the option to buy the shares for less than stock price falls before the shares are sold, you can be left with they’re worth on the market. a large AMT bill in the year of exercise even though the stock actually produced no income. Congress has provided some relief from past ISO-related AMT liabilities, and a new more generous AMT credit is also available. (See page 10 for more information on the AMT credit.) Talk to a Grant Thornton advisor if you have questions about AMT-ISO liability. If the stock from an ISO exercise is sold before the holding period for long-term capital gains treatment expires, the gain is taxed at ordinary income tax rates in a disqualifying disposition. The employer is entitled to a compensation deduction only if the employee makes a disqualifying disposition. If you’ve received ISOs, you should decide carefully when to exercise them and whether to sell immediately or hold the shares received from an exercise. Waiting to exercise until immediately before the ISOs expire (when the stock value may be highest) and then holding on to the stock long enough for long-term capital gains treatment is often beneficial. 15
  17. But acting earlier can also be advantageous However, there are drawbacks. Employers cannot deduct in some situations any NQDC until the executive recognizes it as income, and • Exercise earlier to start the holding period NQDC plan funding is not protected from an employer’s for long-term capital gains treatment sooner. creditors. Employers also must now be in full compliance with • Exercise when the bargain element is small or the relatively new IRS rules under Section 409A that govern NQDC market price is low to reduce or eliminate AMT liability. plans. The rules are strict, and the penalties for noncompliance • Exercise annually and buy only the number of shares that are severe. If a plan fails to comply with the rules, plan will achieve a break-even point between the AMT and participants are taxed on plan benefits immediately with interest regular tax. charges and an additional 20-percent tax. The new rules under Section 409A made several important But beware; exercising early accelerates the need for funds changes. Executives generally must make an initial deferral to buy the stock. It also exposes you to a loss if the value of election before the year they perform the services for the the shares drops below your exercise cost and may create a tax compensation that will be deferred. So, an executive who wants cost if the exercise generates an AMT liability. If the stock price to defer some 2010 compensation to 2011 or beyond generally may fall, you can also consider selling early in a disqualifying must make the election by the end of 2009. Additionally: disposition to pay the higher ordinary-income rate and avoid • Benefits must either be paid on a specified date according the AMT. Tax planning for ISOs is truly a numbers game. to a fixed payment schedule or after the occurrence of a With the help of Grant Thornton, you can evaluate the risks specified event — defined as a death, disability, separation and crunch the numbers using various assumptions. from service, change in ownership or control of the employer, or an unforeseeable emergency. Considerations for restricted stock • The timing of benefit payments can be delayed but Restricted stock provides different tax considerations. Restricted not accelerated. stock is stock that’s granted subject to vesting. The vesting is • Elections to change the timing or form of a payment often time-based, but can also be performance-based, so that the must be made at least 12 months in advance of the vesting is linked to company performance. original payment commencement date. Income recognition is normally deferred until the restricted • New payment dates must be at least five years after stock vests. You then pay taxes on the fair market value of the the date the payment would have been made originally. stock at the ordinary-income rate. However, there is an election under Section 83(b) to recognize ordinary income when you It is also important to note that employment taxes are receive the stock. This election must be made within 30 days generally due when the benefits become vested. This is true even after receiving the stock and can be very beneficial in certain though the compensation isn’t actually paid or recognized for situations. (See Tax planning opportunity 8.) income tax purposes until later years. Some employers withhold an executive’s portion of the tax from the executive’s salary or Understanding nonqualified deferred compensation ask the executive to write a check for the liability. Others pay Nonqualified deferred compensation (NQDC) plans pay the executive’s portion, but this must be reported as additional executives in the future for services being performed now. taxable income. They are not like many other traditional plans for deferring compensation. NQDC plans can favor certain highly compensated employees and can offer executives an excellent way to defer income and tax. Tax planning opportunities 8 Consider an 83(b) election on your restricted stock With an 83(b) election, you immediately recognize the value of the restricted stock as ordinary income when the stock is granted. In exchange, you don’t recognize any income when the stock actually vests. You only recognize gain when the stock is eventually sold. So why make an 83(b) election and recognize income now, when you could wait to recognize income when the stock actually vests? Because the value of the stock may be much higher when it vests. The election may make sense if the income at the grant date is negligible or the stock is likely to appreciate significantly before income would otherwise be recognized. In these cases, the election allows you to convert future appreciation from ordinary income to long-term capital gains income. The biggest drawback may be that any taxes you pay because of the election can’t be refunded if you eventually forfeit the stock or the stock’s value decreases. But if the stock’s value decreases, you’ll be able to report a capital loss when you sell the stock. 16
  18. Chapter 7: Business ownership How to structure your enterprises How you structure, buy and sell business interests has never Chart 5: 2009 corporate income tax brackets been more important. There are many tax considerations that Tax rate Tax bracket can cost or save you money. The most important factor may be the structure you choose for your company. 15% $0 – $50,000 25% $50,001 – $75,000 34% $75,001 – $100,000 Tax treatment of business structures 39% $100,001 – $335,000 Business structures generally fall into two categories: C 34% $335,001 – $10,000,000 corporations and pass-through entities. C corporations are 35% $10,000,001 – $15,000,000 38% $15,000,001 – $18,333,333 taxed as separate entities from their shareholders and offer 35% Over $18,333,333 shareholders limited liability protection. (See chart 5 for corporate income tax rates.) Note: Personal service corporations are taxed at a flat 35% rate. Pass-through entities effectively “pass through” taxation to individual owners, so the business income is taxed at the can affect the ability to finance the business and may determine individual level. (See page 5 for more on individual taxes and which exit strategies will be available. Each structure has its own the individual rate schedule.) Some pass-through entities, such pluses and minuses, and you should examine carefully how each as sole proprietorships and general partnerships, don’t provide will affect you. Call a Grant Thornton advisor to discuss your limited liability protection, while other pass-through entities, individual situation in more detail. such as S corporations, limited partnerships, limited liability If you work in a business in which you have an ownership partnerships and limited liability companies, can. interest, you need to think about employment taxes. Generally Because some pass-through entities can offer the same all trade or business income that flows through to you from limited liability protection as a C corporation, tax treatment a partnership or limited liability company is subject to self- should be a major consideration when deciding between the two employment tax — even if the income isn’t actually distributed structures. (See chart 6 for an overview of key differences.) The to you. But if you’re an S corporation or C corporation biggest difference is that C corporations endure two levels of employee-owner, only income you receive as salary is subject taxation. First, a C corporation’s income is taxed at the corporate to employment taxes. How much of your income from a level. Then the income is taxed again at the individual level when corporation comes from salary can have a big impact on how it is distributed to shareholders as dividends. The income from much tax you pay. (See Tax planning opportunity 9 for more pass-through entities is generally only taxed at the individual information.) owner level, not at the business level. Although this benefit is significant, it is not the only Don’t wait to develop an exit strategy consideration. There are many other important differences in Many business owners have most of their money tied up in their the tax rules, deductions and credits for each business structure business, making retirement a challenge. Others want to make that also need to be considered. You always want to assess sure their business — or at least the bulk of its value — will be the impact of state and local taxes where your company does passed to their family members without a significant loss to business, and owners who are also employees have several other estate taxes. If you’re facing either situation, now is the time to unique considerations. Also, the choice of business structure start developing an exit strategy that will minimize the tax bite. 17
  19. Chart 6: Tax differences based on business structure Pass-through entity C corporation Tax treatment One level of taxation: Two levels of taxation: • Income is not taxed at business level and flows through • Income taxed at corporate level at corporate rates to owners where it is taxed at individual rates • Shareholders then taxed on any dividends they receive Loss treatment • Losses flow through to the owners where they can be • Losses remain at the corporate level and are carried backward taken individually (subject to basis and at-risk limitations) or forward to offset past or future corporate-level income Tax rates • Top individual tax rate is currently 35%, but is scheduled • Top corporate tax rate is generally 35% to increase in 2011 • Income distributed as dividends is taxed a second time, generally at 15% (scheduled to increase to 39.6%) An exit strategy is a plan for passing on responsibility for Sellers should also consider whether they prefer a taxable running the company, transferring ownership and extracting sale or a tax-deferred transfer. The transfer of ownership of a your money. To pass on your business within the family, you corporation can be tax-deferred if made solely in exchange for can give away or sell interests. But be sure to consider the gift, stock or securities of the recipient corporation in a qualifying estate and generation-skipping tax consequences. (See page 31.) reorganization, but the transaction must comply with strict A buy-sell agreement can be a powerful tool. The agreement rules. Although it’s generally better to postpone tax, there are controls what happens to the business when a specified event advantages to performing a taxable sale: occurs, such as an owner’s retirement, disability or death. Buy- • Tax rates are scheduled to increase in 2011. sell agreements are complicated by the need to provide the • The seller doesn’t have to worry about the quality buyer with a means of funding the purchase. Life or disability of buyer stock or other business risks that might insurance can often help and can also give rise to several tax and come with a tax-deferred sale. nontax issues and opportunities. • The buyer benefits by receiving a stepped-up basis One of the biggest advantages of life insurance as a funding in the acquisition’s assets and does not have to deal method is that proceeds generally are excluded from the with the seller as a continuing equity owner, as would beneficiary’s taxable income. There are exceptions to this, be the case in a tax-deferred transfer. however, so be sure to consult a Grant Thornton tax advisor. • The parties don’t have to meet the stringent technical You may also want to consider a management buyout or an requirements of a tax-deferred transaction. employee stock ownership plan (ESOP). An ESOP is a qualified retirement plan created primarily so employees can purchase A taxable sale may be structured as an installment sale if the your company’s stock. Whether you’re planning for liquidity, buyer lacks sufficient cash or the seller wants to spread the gain looking for a tax-favored loan or supplementing an employee over a number of years. Contingent sales prices that allow the benefit program, an ESOP can offer you many advantages. seller to continue to benefit from the success of the business are common. But be careful, the installment sale rules create a trap Assess tax consequences when buying or selling for sellers if the contingency is unlikely to be fulfilled. Also, When you do decide to sell your business — or are acquiring installment sales may not make as much sense in the current another business — the tax consequences can have a major environment because tax rates are scheduled to go up. (See page impact on your transaction’s success or failure. 14 for more information on installment sale considerations when The first consideration should be whether to structure your tax rates have the potential to increase.) transaction as an asset sale or a stock sale. If it’s a C corporation, Careful planning while the sale is still being negotiated is the seller will typically prefer a stock sale for the capital gains essential. Grant Thornton can help you see any trap and find treatment and to avoid double taxation. The buyer will generally the exit strategy that best suits your needs. want an asset sale to maximize future depreciation write-offs. Tax planning opportunities 9 Set salary wisely if you’re a corporate employee-shareholder If you are an owner of a corporation who works in the business, you need to consider employment taxes in your salary structure. The 2.9-percent Medicare tax is not capped and will be levied against all income received as salary. S corporation shareholder-employees may want to keep their salaries reasonably low and increase their distributions of company income in order to avoid the Medicare tax. But C corporation owners may prefer to take more salary (which is deductible at the corporate level), because the Medicare tax rate is typically lower than the 15-percent tax rate they would pay personally on dividends. But remember to tread carefully. You must take a reasonable salary to avoid potential back taxes and penalties, and the IRS is cracking down on misclassification of corporate payments to shareholder-employees. 18
  20. Chapter 8: Charitable giving Saving more by giving better Giving to charity is one of the best tax planning opportunities Outright gifts of cash (which include gifts made via check, because you enjoy not only a sizable tax deduction, but also credit card and payroll deduction) are the easiest. The key is to the satisfaction of doing good. Plus you can control the timing make sure you substantiate them. Cash donations under $250 to maximize your tax benefits. Well-planned gifts can trim the must be supported by a canceled check, credit card receipt or estate tax while allowing you to take care of your heirs in the written communication from the charity. Cash donations of manner you choose. $250 or more must be substantiated by the charity. Despite the simplicity and high AGI limits for outright cash gifts, it Choosing what to give may prove more beneficial to make gifts of property. The first thing to determine is what you want to give to charity: Gifts of property are a little more complicated, but they cash or property. There are adjusted gross income (AGI) limits may provide more tax benefits when planned properly. Your on how much of your gift you get to deduct depending on deduction depends in part on the type of property donated: what you give and who you give it to. Giving directly from long-term capital gains property, ordinary-income property an individual retirement account (IRA) may lower your AGI. or tangible personal property. (See Tax planning opportunity 10 to find out if you are eligible.) Ordinary-income property includes items such as stock held Contributions disallowed due to the AGI limit can be carried less than a year, inventory and property subject to depreciation forward for up to five years. (See chart 7 for the deduction limit recapture. You can receive a deduction equal to only the lesser by donation and the type of charity.) of fair market value or your tax basis. Long-term capital gains property includes stocks and other securities you’ve held more than one year. It’s one of the best charitable gifts because you can take a charitable deduction equal to its current fair market value. Consider donating appreciated property to charity because you avoid paying tax on the long- term capital gain you’d incur if you sold the property. (See Tax planning opportunity 11.) But beware. It may be better to elect to deduct the basis rather than the fair market value because the AGI limitation will be higher. Whether this is beneficial will depend on your AGI and the likelihood of using — within the next five years — the carryover you’d have if you deducted the fair market value and the 30-percent limit applied. Chart 7: AGI limitations on charitable contribution deductions The deduction for your total charitable contributions for the year is subject to a limitation based on your adjusted gross income (AGI) and the type of charity. Public charity or operating foundation Private nonoperating foundation Cash, ordinary-income property and unappreciated property 50% 30% Long-term capital gains property deducted at fair market value 30% 20% Long-term capital gains property deducted at basis 50% 30% 19
  21. Tangible personal property can include things such as a piece So long as certain requirements are met, the property is of art or an antique. Your deduction depends on the type of deductible from your estate for estate tax purposes and you property and the charity, and there are several rules to consider: receive a current income tax deduction for the present value • Personal property valued at more than $5,000 of the remainder interest transferred to charity. You don’t (other than publicly traded securities) must be immediately pay capital gains tax if you contribute appreciated supported by a qualified appraisal. property. Distributions from the CRT generally carry • If the property isn’t related to the charity’s tax-exempt taxable income to the noncharitable beneficiary. If someone function (such as a painting donated for a charity auction), other than you is the income beneficiary, there may be gift your deduction is limited to your basis in the property. tax consequences. • If the property is related to the charity’s tax-exempt A CRT can work particularly well in cases where you own function (such as a painting donated to a museum), non-income-producing property that would generate a large you can deduct the property’s fair market value. capital gain if sold. Because a CRT is a tax-exempt entity, it can sell the property without having to pay tax on the gain. The trust Benefit yourself and a charity with a CRT can then invest the proceeds in income-producing property. This A charitable remainder trust (CRT) may be appropriate if you technique can also be used as a tax-advantaged way to diversify wish to donate property to charity and would like to receive your investment portfolio. (or would like someone else to receive) an income stream for To keep CRTs from being used primarily as tax avoidance a period of years or for your expected lifetime. The property tools, however, the value of the charity’s remainder interest must is contributed to a trust and you, or your beneficiary, receive be equal to at least 10 percent of the initial net fair market value income for the period you specify. The property is distributed of the property at the time it’s contributed to the trust. There are to the charity at the end of the trust term. other rules concerning distributions and the types of transactions into which the trust may enter. Tax planning opportunities 10 Give directly from an IRA if 70½ or older Congress just extended a helpful tax provision that allows taxpayers 70½ and older to make tax-free charitable distributions from individual retirement accounts (IRAs). Using your IRA distributions for charitable giving could save you more than taking a charitable deduction on a normal gift. That’s because these IRA distributions for charitable giving won’t be included in income at all, lowering your AGI. You’ll see the difference in many AGI-based computations where the below-the-line deduction for charitable giving doesn’t have any effect. 11 Give appreciated property to enhance savings Think about giving property that has appreciated to charity. You avoid paying the capital gains taxes you would incur if you sold the property, so donating property with a lot of built-in gain can lighten your tax bill. But don’t donate depreciated property. Sell it first and give the proceeds to charity so you can take the capital loss and the charitable deduction. 20
  22. Reverse the strategy with a CLT Keep control with a private foundation A grantor charitable lead trust (CLT) is basically the opposite Consider forming a private foundation if you want to make of the CRT. For a given term, the trust pays income to one or large donations but also want a degree of control over how that more charities and the trust’s remaining assets pass to you or money will be used. A foundation is particularly useful if you your designated beneficiary at the term’s end. When you fund haven’t determined what specific charities you want to support. the trust, you receive an income tax deduction for the present But be aware that increased control comes at a price: You value of the annual income expected to be paid to the charity. must follow a number of rules designed to ensure that the private (You also pay tax on the trust income.) The trust assets remain foundation serves charitable interests and not private interests. in your estate. There are requirements on the minimum percentage of annual With a non-grantor CLT, you name someone other than payouts to charity and restrictions on most transactions between yourself as remainder beneficiary. You won’t have to pay tax the foundation and its donors or managers. on trust income, but you also won’t receive an income tax Violations can result in substantial penalties. Ensuring deduction. The trust assets will be removed from your estate, compliance with the rules can also make a foundation expensive but there also may be gift tax consequences. Alternatively, the to run. In addition, the AGI limitations for deductibility of trust can be funded at your death, and your estate will receive contributions to nonoperating foundations are lower. an estate tax deduction (but not an income tax deduction). A CLT can work well if you don’t need the current income but want to keep an asset in the family. As with other strategies, consider contributing income-producing stocks or other highly appreciated assets held long-term. 21
  23. Provide influence with a donor-advised fund If you’d like to influence how your donations are spent but you want to avoid the tight rules and high expenses of a private foundation, consider a donor-advised fund. They are offered by many larger public charities, particularly those that support a variety of charitable activities and organizations. The fund is simply an agreement between you and the charity: The charity agrees to consider your wishes regarding use of your donations. This agreement is nonbinding, and the charity must exercise final control over the funds, consistent with the charitable purposes of the organization. To deduct your contribution, you must obtain a written acknowledgment from the sponsoring organization that it has exclusive legal control over the assets contributed. Key rules to remember Whatever giving strategy ultimately makes the most sense for you, keep in mind several important rules on giving: • If you contribute your services to charity, you may deduct only your out-of-pocket expenses, not the fair market value of your services. • You receive no deduction by donating the use of property because it isn’t considered a completed gift to the charity. • If you drive for charitable purposes, you may deduct 14 cents for each charitable mile driven. • Giving a car to charity only results in a deduction equal to what the charity receives when it sells the vehicle unless it is used by the charity in its tax-exempt function. • If you donate clothing or household goods, they must be in at least “good used condition” to be deductible. 22
  24. Chapter 9: Education savings The ABCs of tax-saving education The tax code provides myriad incentives to encourage education. against the alternative minimum tax (AMT). The credit is only This means you have plenty of opportunities to save on your available for the first two years of college education (not room, tax bill while giving your children and grandchildren the best board or books), and it covers only tuition and certain fees at education possible. But it also means you have to consider your colleges, universities or vocational or technical schools. options carefully to make sure you use the tax preferences that The Lifetime Learning credit can be used anytime during will best help your bottom line. the college years as well as for graduate education. But it is less There are generally two ways the tax code offers savings on generous. It provides a credit of up to 20 percent of qualified education. First, there are deductions and credits for education college tuition and fees up to $10,000, for a maximum credit expenses, including the American Opportunity credit, the of $2,000. For 2009 and 2010, it also phases out at much lower Lifetime Learning credit, the tuition and fees deduction, and income threshold than the American Opportunity credit. the student loan interest deduction. The second and often (See chart 8.) better opportunity is a tax-preferred savings account, which comes in the form of either a 529 plan or Coverdell education savings account (ESA). Unfortunately, all of these tax incentives — except 529 savings plans — phase out based on adjusted gross income (AGI). (See chart 8 for the various phaseout thresholds.) Regardless of your approach, making payments directly to educational institutions can help you save in gift taxes. (See Tax planning opportunity 12 for more information.) Deductions and credits The American Opportunity credit was added by the 2009 economic stimulus bill and temporarily replaces the Hope Scholarship credit for 2009 and 2010. The new credit is more generous and has a higher AGI phaseout than the Hope Scholarship credit. It is equal to 100 percent of the first $2,000 of tuition and 25 percent of the next $2,000, for a total credit of up to $2,500. It is also 40 percent refundable and allowed Chart 8: 2009 education tax break AGI phaseouts Single filers Joint filers 529 plan contributions No limit No limit Coverdell ESA contributions $95,000 – $110,000 $190,000 – $220,000 American Opportunity credit (formerly Hope Scholarship credit) $80,000 – $90,000 $160,000 – $180,000 Lifetime Learning credit $50,000 – $60,000 $100,000 – $120,000 Tuition and fees deduction $65,000 – $80,000 $130,000 – $160,000 Student loan interest deduction $60,000 – $75,000 $120,000 – $150,000 23
  25. Bear in mind that you cannot use both credits in the same and if your contract is for four full years of tuition, tuition is year for the same student. If your AGI is too high to claim either guaranteed when your child attends regardless of the cost at credit, consider letting your child take the credit. But neither you that time. Your state may also offer tax benefits for investments nor the child will be able to claim the child as an exemption. in the state qualified tuition programs. The maximum tuition and fees deduction is either $2,000 or College savings plans can only be offered by states and $4,000, depending on your AGI. If you have children who are can be used to pay a student’s qualifying tuition at any eligible out of college and paying back student loans, remind them they educational institution. They offer more flexibility in choosing may be eligible for the student loan interest deduction. schools and more certainty on benefits. If the student doesn’t use all of the account funds, the excess can be rolled over into Section 529 savings plans the plan for another student. Section 529 savings plans allow taxpayers to save in special accounts and make tax-free distributions to pay for tuition, fees, 529 plans have many benefits books, supplies and equipment required for college enrollment. • The plan assets grow tax-deferred, and distributions used The economic stimulus bill passed in February 2009 clarified that to pay qualified higher education expenses are tax-free. computer technology, computer equipment and internet access • Contributions aren’t deductible for federal tax purposes, are allowed as qualified expenses for 529 plans in 2009 and 2010. but some states offer state tax benefits. 529 plans come in two forms, prepaid tuition plans and • There are no income limits for contributing and the college savings plans. Prepaid tuition plans allow you to “buy” plans typically offer much higher contribution limits tuition at current levels on behalf of a designated child. They than ESAs (set by state or private institution sponsors). can be offered by states or private educational institutions, • There is generally no beneficiary age limit for contributions or distributions. Tax planning opportunities 12 Make payments directly to educational institutions If you have children or grandchildren in private school or college, consider making direct payments of tuition to their educational institutions. Your payments will be gift-tax free, and they will not count against the annual exclusion amount of $13,000 (for 2009) or your $1 million lifetime gift tax exemption. Just make sure the payments are made directly to the educational institution and not given to children or grandchildren to cover the cost. 13 Plan around gift taxes with your 529 plan A 529 plan can be a powerful estate planning tool for parents or grandparents. Contributions to 529 plans are eligible for the $13,000 per beneficiary annual gift tax exclusion, so you can also avoid any generation-skipping transfer (GST) tax when you fund a 529 plan for a grandchild — without using up any of your $3.5 million GST tax exemption. Plus, a special break for 529 plans allows you to front-load five years’ worth of annual exclusion gifts ($65,000) in one year, and married couples splitting gifts can double this amount to $130,000. And that’s per beneficiary. 24
  26. But there are disadvantages ESAs have two distinct advantages over 529 plans • You don’t have direct control over investment decisions and • They can be used to pay for elementary and the investments may not earn as high a return as they could secondary school expenses. earn elsewhere. (But you can roll over into a different 529 • You control how the account is invested. plan if you’re unhappy with one plan’s performance.) • There is also a risk the child may not attend college and there However, they also have disadvantages may not be another qualifying beneficiary in the family. • They are not available for some high-income taxpayers due to the AGI phaseout. (Consider allowing others, Contributions to a 529 plan are subject to gift tax, so such as grandparents, to contribute to an ESA if your contributions over the annual gift tax exclusion ($13,000 in AGI is above the phaseout threshold.) 2009) will use up your $1 million lifetime gift tax exemption • The annual contribution limit is only $2,000 per beneficiary. (or be subject to gift tax). But there are opportunities to boost • Contributions generally cannot be made after the beneficiary the account without creating gift tax headaches. (See Tax reaches 18. planning opportunity 13.) • Any balance left in the account when the beneficiary turns 30 will be distributed subject to tax. Coverdell ESAs • Another family member under 30 has to be named Coverdell ESAs are similar to 529 plans. The plan assets grow the beneficiary to avoid a mandatory distribution tax-deferred and distributions used to pay qualified higher and maintain the account’s tax-advantaged status. education expenses are income tax-free for federal tax purposes • As with 529 plans, there is always a risk the child will not and may be tax free for state tax purposes. Contributions are attend college and there is no other qualified beneficiary. also not deductible. 25
  27. Watch out for the kiddie tax Be careful with an alternative technique that was popular in past years: transferring assets to children to pay for education with an account under the Uniform Gift to Minors Act (UGTA) or Uniform Transfer to Minors Act (UTGA). These accounts allow you to irrevocably transfer cash, stocks or bonds to a minor while maintaining control over the assets until the age at which the account terminates (age 18 or 21 in most states). The transfer qualifies for the annual gift tax exclusion, but the expanding “kiddie tax” could limit any tax benefits. The kiddie tax was recently expanded to apply to children up to the age of 23 if they are full-time students (unless they provide over half of their own support from earned income). For those subject to the kiddie tax, unearned income beyond $1,900 in 2009 will be taxed at their parents’ marginal rate. 26
  28. Chapter 10: Retirement savings Using tax incentives for a golden retirement Lawmakers have loaded the tax code with incentives for Because of their tax advantages, contributing the maximum saving for retirement. You may need these tax-advantaged amount allowed is likely a smart move. The tax benefits of these retirement vehicles to build your nest egg unless you can accounts (in the traditional versions) are twofold. Contributions count on a generous defined benefit plan to take care of are usually pretax or deductible, so they reduce your taxable your retirement needs. income. And assets in the accounts grow tax-deferred — Defined benefit plans set a future pension benefit and then meaning you pay no income tax until you make distributions. actuarially calculate the contributions needed to attain the Unfortunately, you must begin making annual minimum benefit. Because they are actuarially driven, the contribution withdrawals from most retirement plans at age 70½. These limits are often higher than other types of plans. But fewer required minimum distributions (RMDs) are calculated using and fewer employers are offering them. your account balance and a life expectancy table. They must be Fortunately, the tax code provides a number of tax- made each year by Dec. 31 or you can be subject to a 50-percent advantaged defined contribution options to help you build penalty on the amount you should have taken out (although enough wealth to live comfortably in retirement. Even if your initial RMD can be deferred until April 1 the following you’ve already amassed your fortune, you may want to year). You may not be required to make distributions if you’re leverage as many retirement tax incentives as possible to still working for the employer who sponsors your plan. (See Tax mitigate your tax burden. planning opportunity 14 to find out when it makes the most sense to make distributions and see page 4 for information on 2009 Defined contributions plans RMD relief.) Defined contribution plans let you control how much is Employer-sponsored defined contribution accounts have contributed. They come in employer-sponsored versions like several advantages over IRAs. For one, many employers offer 401(k)s, 403(b)s, 457s, SIMPLE IRAs and SEP IRAs, or in matching contributions for these accounts, and there are no non-employment versions like Individual Retirement Accounts income limits for contributing. IRAs have strict income limits, (IRAs). All of these accounts have contribution limits, and some but many high-income taxpayers maintain accounts that were allow extra “catch-up” contributions if you’re 50 or older. opened when they were earning less or consist of rollovers (See chart 9 for these limits.) from employer-sponsored plans. Chart 9: 2009 retirement plan contribution limits “Catch-up” contributions mean higher retirement plan contribution limits for workers age 50 or older. Limit for taxpayers under age 50 Limit for taxpayers age 50 and older Traditional and Roth IRAs $5,000 $6,000 401(k)s, 403(b)s, 457s1 $16,500 $22,000 SIMPLE IRAs $11,500 $14,000 SEP-IRAs and defined contribution Keoghs $49,000 $49,000 Includes Roth versions where applicable; the higher 457 plan contribution limits for taxpayers over 50 are only available for government 457 plans. 1 Note: Other factors may further limit your contribution. 27
  29. When to choose a Roth version One option is a profit-sharing plan. This is a defined Three of the defined contribution plans — 401(k)s, 403(b)s contribution plan that allows discretionary employer and IRAs — offer “Roth” versions. The tax benefits of Roth contributions and offers increased flexibility in plan design. accounts are slightly different from traditional accounts. The maximum 2009 contribution is $49,000 or, for those who They allow for tax-free growth and tax-free distributions, include a 401(k) arrangement in the plan and are eligible to make but contributions are not pretax or deductible. catch-up contributions, $54,500. Your specific contribution The difference is in when you pay the tax. With a traditional limit is a function of your income. You can make deductible retirement account, you don’t pay tax on the contributions — 2009 contributions as late as the due date of your 2009 income you only pay taxes on the back end when you take your money tax return, including extensions — provided your plan exists out. For a Roth account, you pay taxes on the contributions up on Dec. 31, 2009. front, but never pay tax again if distributions are made properly. A Simplified Employee Pension (SEP) is a defined A traditional account may look like the best approach contribution plan that provides benefits similar to those of a because it often makes sense to defer tax as long as possible. profit-sharing plan. The maximum 2009 contribution is the But this isn’t always the case. Roth plans can save you more lesser of $49,000 or 25 percent of your eligible compensation if you’re in a higher tax bracket when making distributions (net of the deduction for the contributions), which means you during retirement, or if tax rates have gone up. Plus, there are can contribute $49,000 if your eligible compensation exceeds no required minimum distributions for Roth IRAs. (See Tax $245,000. Catch-up contributions aren’t available with SEPs. planning opportunity 15 for the benefits of setting up a Roth IRA for a child, and check Tax planning opportunity 16 to learn about a new opportunity to roll over from a traditional IRA into a Roth IRA.) Set up your own plan If you’re a business owner or self-employed, you have more flexibility because you can set up a retirement plan that allows you to maximize your contributions. Keep in mind that if you have employees, they generally must be allowed to participate in the plan. Tax planning opportunities 14 Wait to make your retirement account withdrawals Taxpayers have no choice but to begin making distributions from IRAs, 401(k) and 403(b) plans, and some 457(b) plans, once they reach 70½. (See page 4 to learn about the temporary reprieve from required minimum distributions in 2009). But many taxpayers want to know whether they should begin making distributions earlier or wait and make only the required distributions. If your account is appreciating and you don’t need the money immediately, consider waiting to make withdrawals until required. Your assets will continue growing tax-free. Not only will your account balance likely be larger if you wait, but if you live long enough, your total distributions should also be greater. 28
  30. You can establish the SEP in 2010 and still make deductible If you choose a rollover, request a direct rollover from your 2009 contributions as late as the due date of your 2009 income old plan to your new employer’s plan or IRA. If the funds tax return, including extensions. Another benefit of a SEP is that from the old plan are instead paid to you, you’ll need to make it’s much easier to administer than a profit-sharing plan. So if an indirect rollover to your new plan or IRA within 60 days to you have eligible compensation in excess of $245,000 and would avoid the tax and potential penalty on those funds. The check be ineligible to make catch-up contributions to a profit-sharing you receive from your old plan will be net of federal income tax plan, setting up a SEP may be a better option. withholding, but if you don’t roll over the gross amount you’ll be subject to income tax and a potential 10-percent penalty on Considerations after a job change the difference. When you change jobs or retire, you’ll need to decide what to do with your employer-sponsored plan. You may have Avoid early distribution penalties several options. Most withdrawals from tax-deferred retirement plans before It is generally not a good idea to make a lump sum age 59½ will be subject to a 10-percent penalty in addition to withdrawal. You’ll have to pay taxes on the withdrawal, as the normal income tax on the distributions. There are a few well as a 10-percent penalty if you’re under the age of 59½. exceptions to the early withdrawal penalty. You won’t have Your employer is also required to withhold 20 percent for to pay if: federal income taxes. • You become disabled. If you have more than $5,000 in your account, you can • The distributions are a result of inheriting the leave the money there. You’ll avoid current income tax and any plan account. penalties and the plan assets can continue to grow tax-deferred. • You take distributions as substantially equal This may seem like the simplest solution, but it may not be periodic payments for at least five years, with the best. Keeping track of both the old plan and a plan with a the last payment received on or after age 59½. new employer can make managing your retirement assets more • Distributions begin because of early retirement difficult. Plus, you’ll have to be mindful of any rules specific to or other job separation, and the separation occurs the old plan. during or after the year you reach age 55 (except IRAs). You can still avoid any penalties and continue to defer • The distribution is used for deductible medical expenses taxes if you roll over to your new employer’s plan. And this exceeding 7.5 percent of adjusted gross income. may leave you with only one retirement plan to keep track of. • You get divorced and the distributions (except from It can be a good solution, but be sure to first compare the new IRAs) are made pursuant to a qualified domestic plan’s investment options to the old plan’s options. relations order (QDRO). Rolling over into an IRA may be the best alternative. You avoid penalties and continue to defer taxes, and you have nearly 401(k) plans have their own “hardship” distribution rules unlimited investment choices. Plus, you can roll over new based on “immediate and heavy financial need.” But those rules retirement plan assets into the same IRA if you change jobs merely allow a participant to get funds out, not to escape the again. Such consolidation can make managing your retirement income tax or the 10-percent penalty. assets easier. 29
  31. Tax planning opportunities 15 Get kids started with a Roth IRA It’s never too early to start saving, and a Roth IRA can offer your children unique benefits. For one, Roth IRA contributions can be withdrawn tax- and penalty- free at any time and for any reason. Early withdrawals are subject to tax and a 10-percent early withdrawal penalty only when they exceed contributions. Additionally, if a Roth IRA has been open for five years, there are two exceptions to early withdrawal penalties that can be particularly helpful to young IRA owners: • Withdrawals in excess of contributions used to pay qualified higher education expenses are penalty-free, but they’re subject to income tax. • Withdrawals up to $10,000 in excess of contributions used for a first-time home purchase are both tax- and penalty-free. To make IRA contributions, children must have earned income. If your children or grandchildren don’t want to invest their hard-earned money, consider giving them the amount they’re eligible to contribute — but keep the gift tax in mind. (See page 31 for information on the gift tax.) 16 Roll yourself over into a Roth IRA It’s time to prepare for a unique opportunity in 2010 to roll your traditional IRA into a Roth IRA. Starting next year, there will no longer be a $100,000 AGI limit on this option. And it couldn’t have come at a better time. This type of rollover requires you to pay taxes on the investments in your IRA immediately in exchange for no taxes at withdrawal. So why pay taxes now instead of later? • Tax rates are likely to go up. The current top individual tax rate is scheduled to increase from 35 percent to 39.6 percent in 2011. • Your account may also be at its weakest thanks to a downturn that has battered stocks. The upside is that less value in your account means less tax you have to pay on the rollover. Taxes could be a lot higher when your account recovers. • You pay the tax on your rollover from money outside the account. This too has a silver lining. Your full account balance after the rollover becomes tax-free, effectively increasing the amount of your tax-preferred investment. • There are no required minimum distributions for a Roth IRA. So you can take your money out if and when you want to, and whatever is left over can be left to your heirs. 30
  32. Chapter 11: Estate planning Preserve your wealth for family members You’ve spent a lifetime building your wealth, and you’d like The estate tax and GST tax are scheduled for full repeal in to provide for your family and perhaps even future generations 2010, before coming back in 2011 with higher rates and lower after you’re gone. With proper planning, you can do just that — exemptions. This may be unlikely to occur. As this guide went regardless of what happens to the estate and gift taxes in to print, Congress was scheduled to begin considering estate tax the future. reform options before the year’s end. You always want to keep There are three main transfer taxes: the gift tax, estate tax your estate planning strategies up to date for both changes in law and generation-skipping transfer (GST) tax. Estate taxes are and your personal situation. (See Tax planning opportunity 17.) levied on a taxpayer’s estate at the time of death, while gift Check with Grant Thornton for an update on the progress taxes are applied on gifts made during a taxpayer’s lifetime. of legislation, and keep in mind that a full repeal of the estate The GST tax is an additional tax applied to transfers of assets to tax is unlikely any time in the foreseeable future. grandchildren or other family members that skip a generation (including non-relatives 37½ years younger than the donor). Planning for transfer taxes in uncertain times Each transfer tax has its own rates and exemption amounts, Taking steps to minimize transfer taxes is as important as ever. which are scheduled to change drastically in the coming years. Regardless of where exactly the exemption amounts and rates (See chart 10.) end up in the future, there are strategies that can help you minimize your transfer tax burden. First you want to make sure you maximize the exemptions, deductions and exclusions available for each transfer tax. The estate and gift tax have unlimited marital deductions for transfers between spouses. Your estate can generally deduct the value of all assets passed to your spouse at death if your spouse is a U.S. citizen, and no gift tax is due if you passed the assets while alive. There is also no limit on the estate and gift tax charitable deductions. If you bequeath your entire estate to charity or give it all away while alive, no estate or gift tax will be due. The GST includes a lifetime exemption. Your estate may benefit in the long run if you use up this exemption while you’re alive. But remember, you’ll also need to use your gift and estate tax exemptions to make these transfers completely tax-free. Chart 10: Estate, gift and generation-skipping tax rates and exemptions under current law Estate tax Gift tax GST tax Exemption Top rate Exemption Top rate Exemption Top rate 2009 $3,500,000 45% $1,000,000 45% $3,500,000 45% 2010 Estate tax repealed Estate tax repealed $1,000,000 35% GST tax repealed GST tax repealed 2011+ $1,000,000 55% $1,000,000 55% $1,000,000 (+inflation adjustment) 55% 31
  33. The gift tax also offers both a lifetime exemption and a Using business interests in gifting yearly exclusion. Gifting remains one of the best estate planning Interests in a business can save you in transfer taxes, whether strategies. You definitely need to consider using part or all of it is a business you own or a limited partnership you set up. your lifetime exemption. (See Tax planning opportunity 18 for There is a pair of special breaks for business owners: more information.) But first, formulate a gifting plan to take • Section 303 redemptions. Your company can buy back advantage of the annual gift tax exclusion. The annual exclusion stock from your estate without the risk of the payment is indexed for inflation in $1,000 increments and reached $13,000 to the estate being treated as a dividend for income tax per beneficiary in 2009. purposes. Such a distribution generally must not exceed You can double this generous exclusion by electing to split the tax, funeral and administration expenses of the estate, a gift with your spouse. So, even if you want to give to just four and the value of your business must exceed 35 percent of beneficiaries, you and your spouse could gift a total of $104,000 the value of your adjusted gross estate. But be careful. If this year with no gift tax consequences. If you have more there isn’t a non-tax reason for setting up this structure, beneficiaries you’d like to include, you can remove even more the IRS can challenge its validity. from your estate every year. • Estate tax deferral. Normally, estate taxes are due within You can also avoid gift taxes by paying tuition and medical nine months of death. But if closely held business interests expenses for a loved one. As long as you make payments directly exceed 35 percent of your adjusted gross estate, the estate to the provider, you can pay these expenses gift-tax free without may qualify for a deferral. No payment (other than interest) using up your annual exemption. for taxes owed on the value of the business is due until five When deciding what assets to gift, keep in mind the step-up years after the normal due date. The tax then can be paid in basis at death. If it’s likely that the loved ones you give over as many as 10 equal annual installments. Thus, a portion property to won’t sell it before you die, think twice about of your tax can be deferred for as long as 14 years from the giving it to them. If it stays in your estate, the property gets an original due date. automatic step-up in basis to fair market value at the time of your death. This could result in significant income tax savings If you’re a business owner, you may be able leverage your for your heirs upon later sale. Keep in mind that the rules gift tax exclusions by gifting ownership interests that are eligible regarding the step-up in basis could be more complex in 2010 for valuation discounts. So, for example, if the discounts total if the temporary repeal of the estate tax is not amended. 30 percent, you can gift an ownership interest equal to as much as $18,571 tax-free because the discounted value doesn’t exceed the $13,000 annual exclusion. But the IRS may challenge the value, and an independent and professional appraisal is highly recommended to substantiate it. Tax planning opportunities 17 Review and update your estate plan Estate planning is an ongoing process. You should review your plan regularly to ensure it fits in with any changes in tax law or in your circumstances. Family changes like marriages, divorces, births, adoptions, disabilities and deaths can all lead to the need for estate plan modifications. Geographic moves also matter. Different states have different estate planning regulations. Any time you move from one state to another, you should review your estate plan. It’s especially important if you’re married and move into or out of a community property state. Stay mindful of increases in income and net worth. What may have been an appropriate estate plan when your income and net worth were much lower may no longer be effective today. Remember that estate planning is about more than just reducing taxes. It’s about ensuring that your family is provided for and that you leave the legacy you desire. 18 Exhaust your gift-tax exemption Consider exhausting your lifetime gift tax exemption. Using all of the $1 million exemption to give away assets now can save you in the long run. That’s because giving away an asset not only removes it from your estate, but also lowers future estate tax by removing future appreciation and any annual earnings. Assuming modest five-percent after-tax growth, $1 million can easily turn into almost $2.7 million over 20 years. If you gave away the assets during your life, only the original $1 million gift will be added to your estate for estate tax purposes — not the larger value created by the appreciation of the gifted assets. To maximize tax benefits, choose your gifts wisely. Give property with the greatest potential to appreciate. Don’t give property that has declined in value. Instead, sell the property so you can take the tax loss, and then give the sale proceeds. Be aware that giving assets to children under 24 may have unexpected income tax consequences because of the “kiddie tax.” (See page 26 for more information on the kiddie tax.) 32
  34. Whether or not you own a business, there are many reasons your life is a complex task because there are many possible to consider a family limited partnership (FLP) or limited liability owners, including you or your spouse, your children, your company, including the ability to consolidate and protect business and an irrevocable life insurance trust (ILIT). assets, increase investment opportunities and provide business To choose the best owner, consider why you want the education to your family. Another major benefit of these insurance — to replace income, to provide liquidity or to transfer structures is the potential for valuation discounts when interests wealth to your heirs. You must also consider tax implications, are transferred. For example, you can transfer assets, such as control, flexibility, and ease and cost of administration. You rental property or investments, to an FLP, and then gift FLP also may want to consider a second-to-die policy. (See Tax interests to family members. The valuation discount, combined planning opportunity 19.) with careful timing of the gifts, may enable you to transfer substantial value free from gift tax. An FLP can work especially Trusts offer versatile planning tools well for transfers of rapidly appreciating property. Trusts are often part of an estate plan because they can But be careful because the IRS is scrutinizing FLPs. be versatile and binding. Used correctly, they can provide The IRS has had some success challenging FLPs in which the significant tax savings while preserving some control over donor retains the actual or implied right to enjoy the FLP assets, what happens to the transferred assets. There are many or when the donor retains the right to manage the FLP. You different types of trusts you may want to consider: shouldn’t transfer personal-use assets to an FLP, transfer so • Marital trust. This trust is created to benefit the surviving much of your assets as to leave insufficient means to pay for spouse and is often funded with just enough assets to ensure living expenses or have unfettered access to FLP assets for that no estate tax will be due upon the first spouse’s death. your own use. If you wish to create an FLP, you should The remainder of the estate, which would equal the estate discuss the risks with Grant Thornton and determine the tax exemption amount, is used to fund a credit shelter trust. best way to proceed. • Credit shelter trust. This trust is funded at the first spouse’s death to take advantage of his or her full estate tax Leverage life insurance exemption. The trust primarily benefits the children, but the Life insurance can replace income, provide cash to pay estate surviving spouse can receive income, and perhaps a portion taxes, offer a way to equalize assets among children active and of principal, during the spouse’s lifetime. inactive in a family business, or be a vehicle for passing leveraged • Qualified domestic trust (QDOT). This marital trust funds free of estate tax. can allow you and your non-U.S.-citizen spouse to take Life insurance proceeds generally aren’t subject to income advantage of the unlimited marital deduction. tax, but if you own the policy, the proceeds will be included • Qualified terminable interest property (QTIP) trust. in your estate. Ownership is determined by several factors, This type of trust passes trust income to your spouse for including who has the right to name the beneficiaries of the life with the remainder of the trust assets passing as you’ve proceeds. designated. A QTIP trust gives you (not your surviving To reap maximum tax benefits you generally must sacrifice spouse) control over the final disposition of your property some control and flexibility as well as some ease and cost of and is often used to protect the interests of children from a administration. Determining who should own insurance on previous marriage. 33
  35. • Irrevocable life insurance trust (ILIT). The ILIT owns one term. At the end of the term, the principal may pass to the or more insurance policies on your life, and it manages and beneficiaries or remain in the trust. It’s possible to plan the distributes policy proceeds according to your wishes. An trust term and payouts to minimize — or even avoid — a ILIT keeps insurance proceeds, which would otherwise be taxable gift. (See Tax planning opportunity 20 for more on subject to estate tax, out of your estate (and possibly your the benefits of zeroing out a GRAT.) spouse’s). You aren’t allowed to retain any powers over the • Qualified personal residence trust (QPRT). This trust is policy, such as the right to change the beneficiary. The trust similar to a GRAT except that instead of holding assets, the can be designed so that it can make a loan to your estate trust holds your home — and instead of receiving annuity or buy assets from your estate for liquidity needs, such as payments, you enjoy the right to live in your home for a set paying estate tax. number of years. At the end of the term, your beneficiaries • Crummey trust. This trust allows you to enjoy both the own the home. You may continue to live there if the trustees control of a trust that will transfer assets at a later date and or owners agree and you pay fair market rent. the tax-savings of an outright gift. ILITs are often structured • Dynasty trust. The dynasty trust allows assets to skip as Crummey trusts so annual exclusion gifts can fund the several generations of taxation. You can fund the trust either ILIT’s payment of insurance premiums. during your lifetime by making gifts or at death in the form • Grantor-retained trusts. Both grantor retained annuity of bequests. The trust remains in existence from generation to trusts (GRATs) and grantor-retained unitrusts (GRUTs) generation. Because the heirs have restrictions on their access allow you to give assets to your children today — removing to the trust funds, the trust is excluded from their estates. If them from your taxable estate at a reduced value for gift any of the heirs have a real need for funds, the trust can make tax purposes (provided you survive the trust’s term) — distributions to them. Special planning is required if you live while you receive payments from the trust for a specified in a state that hasn’t abolished the rule against perpetuities. Tax planning opportunities 19 Use second-to-die life insurance for extra liquidity Because a properly structured estate plan can defer all estate taxes on the first spouse’s death, some families find they do not need any life insurance at that point. But significant estate taxes may be due on the second spouse’s death, and a second-to-die policy can be the perfect vehicle for providing cash to pay those taxes. A second-to-die policy also has other advantages over insurance on a single life: Premiums are typically lower than those on two individual policies, and a second-to-die policy will generally permit an otherwise uninsurable spouse to be covered. Work with a Grant Thornton estate planner to determine whether a second-to-die policy should be part of your planning strategy. 20 Zero out your GRAT to save more Grantor retained annuity trusts (GRATs) allow you to remove assets from your taxable estate at a reduced value for gift tax purposes while you receive payments from the trust. The income you receive from the trust is an annuity based on the assets’ value on the date the trust is formed. At the end of the term, the principal may pass to the beneficiaries. It’s possible to plan the trust term and payouts to avoid a taxable gift by zeroing out the GRAT. A GRAT is “zeroed out” when it is structured so the value of the remainder interest at the time the GRAT is created is at or just above zero. So, the remainder’s value for gift tax purposes is zero or close to zero. 34
  36. Tax professional standards statement This document supports the marketing of professional services by Grant Thornton LLP. It is not written tax advice directed at the particular facts and circumstances of any person. Persons interested in the subject of this document should contact Grant Thornton or their tax advisor to discuss the potential application of this subject matter to their particular facts and circumstances. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed. To the extent this document may be considered written tax advice, in accordance with applicable professional regulations, unless expressly stated otherwise, any written advice contained in, forwarded with, or attached to this document is not intended or written by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding any penalties that may be imposed under the Internal Revenue Code. The information contained herein is general in nature and based on authorities that are subject to change. It is not intended and should not be construed as legal, accounting or tax advice or opinion provided by Grant Thornton LLP to the reader. This material may not be applicable to or suitable for specific circumstances or needs and may require consideration of nontax and other tax factors. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Grant Thornton LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. No part of this document may be reproduced, retransmitted or otherwise redistributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, re-keying or using any information storage and retrieval system without written permission from Grant Thornton LLP. Portions of this publication were developed by a third-party publisher and are distributed with the understanding that the publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters and recommend you consult an attorney, accountant, tax professional, financial advisor or other appropriate industry professional. This publication reflects tax law in effect as of September 2009. Some material may be affected by changes in the laws or in the interpretation of such laws. Therefore, the services of a legal or tax advisor should be sought before implementing any ideas contained in this guide. © Grant Thornton LLP All rights reserved U.S. member firm of Grant Thornton International Ltd

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