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A List of Key Expired Tax Breaks

Several federal income tax breaks for individuals and businesses expired at the end of 2013. Although we're solidly into 2014, Congress has, so far, failed to extend many of the tax savings opportunities that you've become accustomed to. (Some observers predict that Congress won't act for months.)

Here's a summary of some noteworthy deductions and credits that won't be available, or will be significantly reduced, in 2014. Many of these federal income tax breaks were available (at varying levels) for several years before expiring on New Year's Eve.

Expired Tax Breaks for Individuals

Option to Deduct State and Local Sales Taxes

In 2013, individuals had the option of claiming an itemized deduction for general state and local sales taxes instead of claiming an itemized deduction for state and local income taxes. This option was beneficial for taxpayers who live in states with no personal income taxes and taxpayers who pay only minimal state income taxes.

Tax-Free Treatment for Forgiven Principal Residence Mortgage Debt

For federal income tax purposes, cancelled debts generally count as taxable cancellation of debt (COD) income. However, a temporary exception applied to COD income from cancelled mortgage debt that was used to acquire a principal residence. Under the temporary provision, up to $2 million of COD income from principal residence acquisition debt that was cancelled between 2007 and 2013 was treated as a tax-free item for federal income tax purposes.

Charitable Donations from IRAs

Individual retirement account (IRA) owners who had reached age 70 1/2 by December 31, 2013, were allowed to make charitable donations of up to $100,000 directly out of their IRAs in 2013. The donations counted as IRA required minimum distributions.

So, charitably-inclined seniors who had more IRA funds than needed could reduce taxes by arranging for IRA donations to take the place of taxable required minimum distributions in 2013.

Deduction for Higher Education Tuition and Related Fees

In 2013, you could deduct up to $4,000 (or up to $2,000 for higher-income folks) for qualifying higher education tuition and related feeds paid for you, your spouse, or your dependents.

$500 Energy-Efficient Home Improvement Credit

For 2013, taxpayers could claim a tax credit of up to $500 for certain energy-saving improvements to a principal residence.

Salary Reduction for Transit Passes

Your employer may allow you to sign up to reduce your taxable salary to pay for mass transit passes to commute to and from work. In 2013, the maximum monthly amount you could set aside on a tax-free basis was $245. The maximum monthly amount for 2014 will be only $130 unless Congress decides to allow a larger amount. (If that happens, the larger amount would be $250.)

$250 Deduction for Teachers' School Expenses

For 2013, teachers and other personnel at K-12 schools could deduct up to $250 of school-related expenses they paid out of their own pockets, regardless of whether they itemized or not.

Deduction for Home Mortgage Insurance Premiums

In 2013, eligible taxpayers were allowed to treat qualifying personal residence mortgage insurance premium amounts as deductible home mortgage interest.

Charitable Qualified Conservation Contributions

Charitable qualified conservation contributions are donations of real property interests (including remainder interests and easements) that restrict the use of real property. For individuals, the maximum write-off for 2013 qualified conservation contributions of long-term capital gain property was increased from the normal 30% to 50% of adjusted gross income.

In addition, qualified conservation contributions were not counted when calculating an individual's allowable 2013 write-offs for other charitable contributions. Qualified conservation contributions in excess of what could be written off in 2013 could be carried forward for 15 years (only a five-year carryover period is allowed under the normal rules). For an individual who was a qualified farmer or rancher, the qualified conservation contribution write-off for 2013 donations of farm or ranch real property could be as much as 100% of the donor's adjusted gross income.

Zero Percent Tax Rate on Future Gains from Qualified Small Business Stock

For qualified small business corporation (QSBC) stock that was issued in calendar year 2013, a 100% federal gain exclusion break is potentially available. That equates to a 0% federal income tax rate on future profits from selling QSBC shares down the road. You must hold the shares for more than five years to be eligible, and many companies will fail to meet the definition of a QSBC. Also, C corporation shareholders are ineligible. For QSBC shares issued in 2014, the "normal" gain exclusion percentage of 50% will apply unless Congress restores the 100% gain exclusion deal.

Personal Credit for Alternative Fuel Vehicle Refueling Property

In 2013, individuals could claim a federal tax credit for up to 30% of the cost of installing non-hydrogen alternative fuel vehicle refueling property. This credit could be claimed for expenditures such as equipment to recharge electric-powered car batteries at a principal residence. For individuals, the annual cap for this credit was only $1,000. A credit for hydrogen refueling property is allowed through 2014.

Expired Tax Breaks for Businesses

Research and Development Credit

Businesses are no longer eligible for a long-standing tax break for increasing qualifying R&D expenditures (QREs), including wages, supplies, and certain consulting and contract research fees related to qualified research activities. In 2013, this credit generally equaled 20% of the amount by which current-year QREs exceeded a base-period amount (subject to a 6.5% maximum).

Fifty Percent First-Year Bonus Depreciation Deduction

For qualifying new (not used) assets that were placed in service (hooked up and ready for use) in calendar year 2013, taxpayers could write off 50% of the cost in the asset's first year of service. Qualifying assets included most software, certain "heavy" passenger vehicles, non-passenger vehicles, and equipment.

Expanded Section 179 Deductions

For tax years that began in 2013, eligible small and medium-sized businesses could immediately write off up to $500,000 of qualifying new and used assets, including most software, certain "heavy" passenger vehicles, non-passenger vehicles, equipment, and up to $250,000 of qualifying real estate improvements. Assets had to be placed in service (hooked up and ready for business use) by the end of the tax year that began in 2013 to be eligible.

The maximum Section 179 deduction for tax years beginning in 2014 will be only $25,000, and no Section 179 deductions will be permitted for real estate improvements.

Fifteen-Year Depreciation for Leasehold Improvements, Restaurant Property, and Retail Space Improvements

Generally, taxpayers must depreciate non-residential real property straight-line over 39 years for federal tax purposes. But 15-year straight-line depreciation was allowed for the cost of qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail space improvements that were placed in service in 2013 (but not expensed under Section 179 or eligible for the 50% first-year bonus depreciation deal in 2013).

Credit for Building Energy-Efficient Homes

In 2013, homebuilders were eligible for a $2,000 tax credit for each new energy-efficient home they built in the United States, including manufactured homes. Firms could also claim this credit for substantially reconstructing and rehabilitating an existing home and making it more energy efficient. Homes that did not fully meet the energy-efficiency standards could qualify for a reduced $1,000 credit. A home had to be sold by December 31, 2013, for use as a residence to qualify for the credit.

Credit for Manufacturing Energy-Efficient Appliances

The credit for manufacturing energy-efficient dishwashers, clothes washers, and refrigerators in the U.S. expired at the end of 2013. The credit amounts per unit were $75 for qualifying dishwashers, $200 for qualifying refrigerators, and $225 for qualifying clothes washers.

Business Credit for Alternative Fuel Vehicle Refueling Property

In 2013, businesses could claim a federal tax credit for up to 30% of the cost of installing non-hydrogen alternative fuel vehicle refueling property. This credit could be claimed for expenditures such as a gas station's costs to install ethanol, compressed natural gas, or hydrogen refueling pumps or equipment to recharge electric-powered car batteries. For businesses, the annual cap for each location for this credit was $30,000. A credit for hydrogen refueling property is allowed through 2014.

S Corporation Built-In Gains Tax Exemption

If you operate a corporation that recently converted from C to S status, a corporate-level built-in gains tax (also known as the BIG Tax) may apply when certain S corporation assets, including receivables and inventories, are converted to cash or sold within the "recognition period." The recognition period is normally the 10-year period that begins on the date when the corporation converted from C to S status.

For eligible built-in gains that were recognized in tax years beginning in 2013, however, there was an exemption from the BIG Tax. The exemption applied if the fifth year of the S corporation's recognition period had gone by before the start of the tax year that began in 2013.

Enhanced Charitable Deduction for Food Donations

Businesses that were not operated as C corporations were entitled to an enhanced charitable contribution if they donated food to qualified charities in 2013. This provision was intended for non-C corporation businesses that have food inventories, such as restaurants and grocery stores. These deductions are normally limited to the taxpayer's basis in the food or its fair market value, whichever is lower. But in 2013, the temporarily enhanced deduction equaled the lesser of:

  • The taxpayer's basis in the food plus one-half the value in excess of basis; or
  • Two times the taxpayer's basis in the food.

The same enhanced deduction rule has been available to C corporations for years, and still is. The taxpayer's total charitable contribution deduction for food donations under this provision generally could not exceed 10% of net income for the tax year from sole proprietorships, S corporations, or partnerships (or other non-C corporation entities) from which the food donations are made.

Favorable Rules for C Corporation Farm and Ranch Qualified Conservation Contributions

Qualified conservation contributions are charitable donations of real property interests, including remainder interests and easements that restrict the use of real property. For qualified C corporation farming and ranching operations, the maximum write-off for qualified conservation contributions was increased from the normal 10% of adjusted taxable income to 100% of adjusted taxable income in 2013. Qualified conservation contributions in excess of what could be written off in 2013 could be carried forward for 15 years.

Favorable Rule for S Corporation Donations of Appreciated Assets

For tax years beginning in 2013, a favorable shareholder basis rule applied for stock in S corporations that made charitable donations of appreciated assets. For such donations, each shareholder's tax basis in the S corporation's stock was only reduced by the shareholder's pro-rata percentage of the company's tax basis in the donated assets.

Without this provision, a shareholder's basis reduction would have equaled the passed-through write-off for the donation (a larger amount than the shareholder's pro-rata percentage of the company's tax basis in the donated asset). This provision was taxpayer-friendly because it left shareholders with higher tax basis in their S corporation shares, which is almost always beneficial to shareholders. 

Successful Business Acquisition: Top Tips to Ensure Success When Purchasing an Existing Business

Whether you are an established CEO looking to expand your business empire or a first-time entrepreneur, there is no doubt that the acquisition of an existing business can be an appealing prospect. In the current economic climate, both in the US and worldwide, banks are increasingly more reluctant to loan money to start-up businesses without a proven track record to lend gravitas and security to the deal. Instead, they remain far more likely to consider providing the finances to acquire an existing company, with an accompanying existing customer base and predictable sales forecast. By contrast, in the US alone, it is estimated that a mere 10% of start-up businesses are able to successfully secure the loan that they require at the outset of their enterprise; a figure that is replicated closely in other comparable countries, such as the UK. It is small wonder then that so many people choose instead to invest time, effort and finances into an existing business venture. However, despite its many advantages, a business acquisition is not by any means risk free. According to Gary Jackson, Director for the Lexbridge International Mergers and Acquisitions Group in the Dallas area, there are a number of common pitfalls that can easily be avoided, with the right knowledge and prior preparation.

The Importance of Getting the ‘Real’ Picture of Your Business Acquisition

If you are considering a merger, it is vitally important to take into account the compatibility of your existing company and the new venture. If the acquisition sits too far wide of your present company’s core competencies and values, then the merger is unlikely to stand comfortably as a cohesive business vision. Ensure that you gather as much information as possible about the company and examine their current method of selling. If, for example, your existing enterprise focuses predominantly on online sales, then acquiring a company that sells mainly through face-to-face selling may be a step too far out of your comfort zone. Likewise, for those without an existing company, be sure to familiarize yourself with the nature of the business; its day to day operations, existing business practices and company ethos. If these core values and practices jar uncomfortably with your own business vision, then think twice before investing.

Never Assume When it Comes to Finance

As might be predicted, financing the acquisition of a business is one of the most common problems that people encounter. It is easy to fall into the trap of presuming that your bank will offer the required loan; based on the premise that it is being taken in order to finance the purchase of an existing company. The truth is that in times of economic recession, banks are incredibly cautious when offering any loan and will examine your proposed purchase in great detail. However, if the bank declines to offer you the required amount, don’t panic. There are other routes available. Many people in the US are following the example of UK business owners, and opting instead for a bridging loan. The advantages of a bridging loan, as explained by top UK comparison site Money.co.uk is that “the turnaround for business bridging loans can be very quick, less than 24 hours in some cases, so you get the finance you need when you need it”, but it is important to note that bridging loans are only to be considered if you are confident about being able to repay quickly. If the business you are looking to acquire has an excellent track record of generating sales and making profit swiftly, then you may want to consider this as a calculated risk.

Call for an Expert!

Another common pitfall is making the assumption that you can manage the sale by yourself. Of course, it is possible to manage the acquisition without external help, but the realities of the process mean that, without expert guidance, the procedure can be a stressful one at best, and at worst, a complete failure. A professional will not only help with completing the purchase and with procuring the best possible price on your behalf, but will also offer practical advice on assessing the market, not to mention help with financial and tax planning. Investing in the services of a professional is often considered by many business owners as the best investment made throughout the purchase process, allowing the buyer to focus on other (more exciting!) aspects of the sale.

Make a Check-List

Before you embark upon a business acquisition, it is a great idea to have a check-list ready; a vital list of aspects to consider whilst preparing to make one of the biggest investments of your life. Here are a few suggestions of things to consider:

  • Are you ready to make the investment? Is your existing business ready to take on the extra growth? Or, if purchasing a ‘first time’ business, are you mentally and physically prepared for the time and effort involved?
  • Starting the sale. Do some research to find the right business advisor to help you get started, and prepare to sign the letter of intent; indicating your serious intention to make the purchase.
  • Obtain your approvals. Your adviser will guide you through this, but you will need to obtain necessary approvals from government regulators, shareholders, and in some cases, other third parties.
  • Alerting the forces. If you are planning a merger, take time to consider how you are going to let your existing staff know about the acquisition and what the impact will be on them. If your acquisition includes existing staff, think about how to conduct a successful ‘marriage’ between your current and new staff members. A successfully functioning team is of vital importance for a profitable business.

With the right level of preparation and a realistic outlook, a business acquisition does not need to be a stressful or worrying process. With the help of an expert business adviser and with the right level of initial research into the business and the market, there is every reason that your purchase will proceed smoothly and that you can enjoy success with your new company. 


November 2013 - Year End Tax Planning Seminar 

Check out our extended presentation from the recent Year End Tax Planning Tools for the Business Owner on SlideShare.

September 2013 - Wurst Fest is Back! 

This year, Cornwell Jackson is joining with Sagiss to host the 13th annual Wurst Golf Fest, benefitting The Samaritan Inn and Journey to Dream. Please help us reach our fundraising goal of $40,000 for these local causes by participating in the Wurst tournament this year. 

The Samaritan Inn

The Samaritan Inn was established in 1984 after community leaders joined together to address the issue of homelessness in Collin County. Twenty five years later, The Samaritan Inn is still the only homeless program in a county of over 762,000 residents. All services and support are provided free of charge through funding made from donations by churches, service groups and organizations, corporations and individuals. The Samaritan Inn is also a member of the United Way of Collin County.

Journey to Dream

In 2004, two mothers who witnessed firsthand the devastating toll destructive behaviors has on kids founded Journey to Dream, a 501(c)(3) nonprofit corporation. Their efforts to harness the power of positive peer pressure and use methods relevant to youth culture, like hip hop music and media, proved effective in reaching young people. Programs empower students to use their life experiences and voices to positively influence other students to live free from destructive behaviors like alcohol and drug abuse, cutting, bullying, dating violence, and suicide.  Since 2004, Journey to Dream have positively impacted over 30,000 lives.

For more information or questions about the tournament, please contact Beth Smith, at 972-202-8035 or at Beth.Smith@cornwelljackson.com. To access the registration form, please click here or visit www.wurstgolffest.com


Cornwell Jackson and Underwood Perkins, P.C. are proud to present the 2012 Wurst Golf Fest, benefiting City House.

The Wurst Golf Fest, a charity golf tournament benefiting City House, is back for the 12th straight year. Cornwell Jackson and Underwood Perkins want you to join in on the fun! Mark your calendars: Tuesday, September 25, 2012 Stonebridge Ranch Country Club – The Hills Course located at 5901 Glen Oaks Drive, McKinney, TX 75070.

The Wurst Golf Fest isn't your typical golf tournament. As one walks the fairways, they might see a live Bavarian band playing, grown men dressed in lederhosen, sausages and other German style cuisine on the grill and fellowship united by charity and the love for the game of golf. Cornwell Jackson and Underwood Perkins will provide food, beverages, golf and a fun time for both those interested in volunteering, sponsoring, or competing to win it ALL.

Help us reach our fundraising goal of $40,000 for City House.  City House is an emergency youth shelter located in Plano that has been providing care, shelter, and transitional living arrangements for over 24 years. In 2011, Wurst Fest raised $33,500 for City House, and we fully expect to build upon last year's success.

Beyond helping the children and youth of Collin County, there are various forms of recognition for our company. Several levels of sponsorship are available to meet any budget requirements and recognition your company desires.  Sponsorship helps offset the cost of the tournament so that more money can go directly to City House.

Contact Heath Cowgill at 972-202-8037 or Heath.Cowgill@cornwelljackson.com.
You can also visit
www.wurstgolffest.com for more information. 

Burdensome 1099 Reporting Requirements Are No Longer

In March we shared the gratifying news that Congress had come to its senses and was in the process of repealing the burdensome 1099 reporting requirements that were part of 2010's Patient Protection and Affordable Care Act.

Well the good news keeps coming. On April 5, 2011, the Senate passed the Comprehensive 1099 Taxpayer Protection and Repayment of Exchange Subsidy Overpayments Act, which will repeal the rules that would have required businesses to file 1099 tax forms beginning next year for all purchases over $600. The bill is expected to be signed by the president.

Thanks to this just-passed law, none of the attempted 1099 changes will take effect. So if you’re currently handling 1099s and payee statements without any trouble, you can continue with the status quo. If not you might want to start complying as the harsher penalties from the 2010 law are still valid.

In case you’re wondering how Congress compensated for the estimated $22 billion of revenue that was expected from the attempted 1099 changes, the Feds will try to recover the revenue (which some consider grossly overestimated in the first place) by collecting more “excess advance payments” of health insurance premium assistance credits collected by individuals. This change will take effect in 2014.

What Won't Be Changing

The longstanding 1099 rules will continue to apply without any changes:

Businesses are required to report various types of payments to the IRS and to recipient taxpayers. For instance, when Company A pays $600 or more during a calendar year to John Doe, an unincorporated independent contractor, for services rendered, Company A must file a Form 1099-MISC with the IRS and must send a copy to John Doe (a so-called payee statement).

Other types of payments that businesses must report to the IRS on 1099s and to payees on payee statements:

  • Commissions, fees and other forms of compensation paid to a single unincorporated payee when the total amount paid in a calendar year is $600 or more.
  • Interest, rents, royalties, annuities and other income items paid to a single unincorporated payee when the total amount paid in a calendar year is $600 or more.

Note: Penalties for failing to file 1099s and issue payee statements were increased by a 2010 law. The increased penalties ($100 or more for each failure to file 1099s AND payee statements) remain in effect. So, each time you do not file a 1099 and issue a related payee statement, the IRS can still assess a penalty of $200 or more.

Most payments to corporations are exempt from any 1099 reporting requirements, except for payments of $600 or more to a corporate law firm, which must be reported on a Form 1099-MISC for that year.

There is generally no requirement to issue 1099s to report payments for property (merchandise, raw materials, equipment, etc.).

Tax Relief Act of 2010

The House approved the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (HR 4853) by a vote of 277 to 148 on December 16. The Senate passed it on December 15. The $858 billion measure extends the Bush-era tax rates, provides unemployment benefits, patches the alternative minimum tax and provides a two-year break for inheritance taxes.

The measure now goes to the White House where President Obama is expected to sign it.

For your convenience we've summarized the key provisions of the Tax Relief Act of 2010. You can read it by clicking here.

If you have any questions about the Tax Relief Act, please contact us at (972) 202-8000.


New Small Business Law Provides Tax Incentives

After several failed attempts to arrive at a consensus, Congress finally passed the Small Business Jobs and Credit Act. This vital new legislation, which President Obama signed on September 27, 2010, provides various tax incentives targeted to small business owners.

Here are several key provisions in the new law.

Enhanced Section 179 Depreciation Deductions: Under Section 179 of the Internal Revenue Code, a business can currently deduct the cost of qualified property placed in service during the year, within an annual limit. Prior to the new law, the limit for 2010 was $250,000, and the maximum deduction was subject to a phase out for annual purchases above $800,000. The new law increases the maximum deduction to $500,000 for 2010 and 2011 with a phase-out threshold of $2 million. Eligible assets include computers, office equipment and furniture. Certain real estate improvement costs now qualify for Section 179 deductions of up to $250,000.

Bonus Depreciation is Back for 2010: The new law also restores bonus depreciation, which expired after 2009. A business may claim a deduction equal to 50 percent of the cost of qualified assets, which include vehicles. (An additional year of bonus depreciation through 2011 is allowed for property with a cost recovery period of 10 years or longer and certain transportation property.)

Qualifying new assets must be placed in service by December 31, 2010.

Note: There is a tax-saving opportunity for businesses that are able to take advantage of both Section 179 and 50 percent first-year bonus depreciation. These two breaks can be combined to offset a large part, or perhaps all, of a company's major acquisitions for the year. While larger businesses may be ineligible for the Section 179 deduction, 50 percent first-year bonus depreciation is available to any business regardless of size.

S Corporation Disposition Rules are Eased: After a C corporation converts to S corporation status, it may be liable for the built-in gains (BIG) tax if it sells or otherwise disposes of appreciated property within a specified time period. The normal recognition period of 10 years was shortened to seven years for disposition in tax years beginning in 2009 and 2010. The new law reduces this period still further to only five years for dispositions in tax years beginning in 2011.

Start-Up Expense Deductions Increase: Prior to the new law, a taxpayer could deduct up to $5,000 of qualified business start-up expenditures for new ventures just getting off the ground. The maximum $5,000 deduction was phased out for expenses over $50,000. The new law doubles the maximum deduction for 2010 to $10,000 with a $60,000 phase-out threshold. Note that these figures are scheduled to revert to their prior amounts in 2011.

Restrictions on Business Credits Removed: With limited exceptions, general business credits cannot be used to offset a taxpayer's alternative minimum tax (AMT) liability. The new law removes this restriction for eligible small businesses. To qualify average annual gross receipts of a non-public corporation, partnership or small proprietorship can't exceed $50 million for the prior three years. In addition, beginning in 2010, an eligible small business may carry back general business credits for five years instead of one year.

Qualified Small Business Stock Gets Better Tax Treatment: Assuming certain requirements are met, an investor in qualified small business stock may exclude part of the gain from the sale of the stock after a five-year holding period. Normally, the tax exclusion is 50 percent for QSBS, which is taxed at the 28 percent rate, but the 2009 stimulus law increased the exclusion to 75 percent for acquisitions after February 17, 2009, and before January 1, 2011. The new law allows 100 percent exclusion for acquisitions from the date of enactment through December 31, 2010.

Cell Phone Recordkeeping is Less Burdensome: Previously, cell phones were treated as listed property for tax purposes, therefore triggering the same strict substantiation rules that apply to business use of vehicles. In other words, in order to claim deductions, taxpayers had to track business and personal use. The new law removes these requirements for cell phones and similar communication devices and treats employer-provided devices as tax-free fringe benefits.

Self-Employed Taxpayers Get a Break on Health Insurance Costs: A self-employed individual must pay self-employment tax comparable to the Social Security tax paid on employee wages. For 2010, eligible self-employed people can deduct health insurance premiums from the self-employment income subject to employment tax. This tax break is a limited one-year window of opportunity.

Contributions to Roth Accounts are Made Easier for Some Taxpayers: Roth IRAs provide tax-free treatment for qualified distributions. Beginning in 2011, participants in state and local goverment-operated 457 plans (other than employees of non-profits) can contribute deferred amounts to designated Roth accounts. Participants in 401(k) and 403(b) plans already have this ability. Also, participants in 401(k), 403(b) and 457 plans can roll over account balances to a Roth, subject to tax on pre-tax contributions and earnings. This provision takes effect on the date of enactment. For rollovers in 2010, account owners can opt to have the taxable income split between 2011 and 2012.

Businesses and individuals may want to take action before the end of the year based on these significant new law changes.

Revenue Raisers: How did Congress pay for the new law?

To offset the cost of the tax incentives in the new law, revenue raisers were imposed, including the following:

  • New information reporting requirements on rental real estate activities for annual payments of $600 or more made after December 31, 2010. In other words, landlords will have to file 1099 forms for service providers, such as plumbers, painters and landscapers.
  • Increased failure-to-file penalties on information returns.
  • Allowing levies to be issued against federal contractors prior to a collections due process hearing.
  • Treatment of debt guarantees by certain foreign entities as U.S. source income.
  • Increased estimated tax penalties in 2015 for large corporations.

Annuities: Surrender Strategies

A 2007 Wall Street Journal article commented on the mistakes that investors often make in disposing of an unwanted annuity (Maxey, July 9, 2007). A key point was that those looking to cash in an annuity often do so in haste, ignoring the potential tax cost and surrender charges.

In general, annuities come in two flavors. Traditional annuities grow based on the general interest crediting rate of the issuing insurance company, while variable annuities hold underlying stock and bond mutual funds. In this second case, the cash value may increase or decrease depending upon the performance of the underlying investments. A common feature of both forms is the internal insurance charge, which tends to be a drag on performance compared to a similar investment in non-annuity form.

But annuities have a significant tax deferral advantage. The growth in the cash surrender value of the underlying investments is not taxable until annuity payments are received or a cash-out is taken by the owner.

The Wall Street article commented on how some investors who surrender an unwanted annuity are surprised by the large tax cost. That is certainly a valid observation. An annuity that has been untouched for 30 years, for example, typically has appreciated significantly and can bring a substantial tax bill. The amount received is considered ordinary income, even though the underlying investments may represent capital appreciation in stocks and funds that otherwise would be capital gain.

For those contemplating the cash-in of an unneeded annuity, the article commented on the importance of shopping around, both with the issuing insurer and also with the secondary market. Some annuities are capable of a sale to a third party, giving the investor another option.

But what about taking advantage of a key annuity attribute: a lifetime payout that you cannot outlive? An annuity can generally be “annuitized,” with the issuing insurance company committing to a lifetime monthly payout. This shifts the risk of extended longevity to the insurance company. Using an annuity as a core monthly retirement income source is probably an underutilized feature.

And there are other choices as well. Perhaps the annuity should simply be left to your heirs. Or how about leaving it to charity where all of that accrued income might avoid taxes?

Unfortunately, designating your heirs as beneficiaries does nothing to cleanse the significant deferred income tax cost. Unlike many other investments, annuities do not receive a fresh tax cost when they pass through an estate. Accordingly, all of that income will still be taxable to your children or other heirs when they cash in the annuity after you are gone.

Charitable transfers, of course, fare better. If an annuity is transferred to a charity during lifetime, the owner must recognize the deferred income at the point of transfer. But an offsetting charitable deduction is allowed for the full proceeds of the annuity that move to the charity. Generally, this should produce a charitable deduction that is larger than the income by the sum of the owner’s investment in the annuity contract.

Another option is to pass the annuity to charity after death by naming a charity as the beneficiary. For those who desire to leave some amount to charity as a bequest, using an annuity is a tax-efficient choice. The charity is not subject to any income taxes when it receives the proceeds. Other assets with no deferred tax liabilities can then be left to your heirs.

Individual Tax Developments

New Complex Kiddie Tax Rules

For many years, Congress has imposed the infamous “kiddie tax” on the unearned income of a younger child. The motivation has been to prevent parents from shifting investment income, such as interest, dividends and capital gains, to the lower bracket tax returns of their children. From its inception, the kiddie tax applied the parents’ tax rate to the unearned income of a child under age 14. But beginning in 2006, Congress extended the kiddie tax to reach those under age 18.

The kiddie tax allows the child to have only $1,700 of investment income and gains at the child’s low rate. Any excess is taxed at mom and dad’s top tax rate.

Now, in the recent tax legislation, effective beginning with the 2008 tax year, the kiddie tax has been expanded in a very complicated manner to potentially reach children through age 23! This expanded kiddie tax actually aims at two groups who have attained age 18: (1) those who have their 18th birthday during the year, and (2) those who are in full-time student status for at least five months of the year and attain their 19th through 23rd birthday during the particular tax year.

But there is a further test for those in this age 18-23 upper tier group. For the kiddie tax to apply, the individual must have earned income, such as from wages and self-employment income, that does not exceed one-half of the amount of the individual’s support for the tax year. In measuring support, amounts received as a scholarship are not taken into account.

Support, of course, is a figure that is difficult to quantify. Support takes into account the various expenditures for that child during the year, such as food, shelter, clothing, medical care, education, recreation and the like. Often, support is provided in kind, such as lodging provided by parents. In that case, the item is measured in terms of its fair market value. In determining support, only amounts actually expended or provided during the particular year are considered. If the child has low personal earnings (wages and self-employment income) compared to the support amount, he or she will be subject to the kiddie tax during the years 18-23, assuming he or she is also in student status. But if the child has a larger wage amount compared to his or her support, the child will be exempt.

Example: Ben is a college student, age 20, with several scholarships. During 2008, items expended for Ben’s support include room, board, tuition and other items that total $26,000. However, Ben has received several scholarships in the total amount of $6,000 that reduce the outlay for his tuition. Accordingly, his total support for 2008 is $20,000. Ben has a W-2 from employment at his school during 2008 for $7,000. Ben is subject to the kiddie tax, because his earned income of $7,000 does not exceed $10,000 (half of his support for the year excluding the amount covered by scholarships).

If Ben had greater wages for 2008, such as $11,000 in total employment, he would not be subject to kiddie tax. In that case, Ben could recognize interest and dividend income or sell securities with significant capital gain recognition without imposition of his parents’ tax rate on his unearned income.

Observation: A surprising aspect of this kiddie tax expansion is that its application has no bearing on the child’s dependency deduction. The dependency exemption for a student or young adult generally goes to the party (parent or child) that provided over half of that child’s support for the year. The kiddie tax, instead, simply looks to the W-2 and self-employment income of the student, and does not consider who provided the sources of support for the child for the year.

In many cases, particularly among upper income families, a student may not be a dependent of the parents because the student’s assets (received through earlier gifts from parents or grandparents) have provided over half of the student’s support for the year. And yet that student could be subject to kiddie tax at the parents’ tax rate, simply because the student had low W-2 income for the year. It is even possible under this set of rules to have the kiddie tax apply to an estranged child who no longer is in communication with the parents!

Strategies: Here are some thoughts about how to react to this new kiddie tax. First, because the age 18-23 rule does not take hold until 2008, those who have children presently in that age group should consider recognizing gains and investment income in their tax returns during 2007. A 19 year old’s mutual funds and stocks can be sold in this year without any kiddie tax, but it may be a different story next year.

Secondly, is it possible the child’s W-2 and self-employment earnings could approach over half of their support amount, so that the 2008 kiddie tax did not apply? If so, adding to that W-2 income by employing the child in a family business could be of benefit.

Investment strategies for saving for college for a child will need rethinking. Rather than build up funds that will now be cashed in kiddie tax years when needed for college, consider the efficiency of state-sponsored 529 plans. These investments are never taxed if withdrawn and expended for higher education.

Finally, for many, the kiddie tax may not be that costly, at least with respect to capital gains. For example, if a child is holding unsold stocks that have been received as a gift from parents, the sale will produce a capital gain. At the child’s rate, it would be taxed at 0% in 2008, but with kiddie tax it is a 15% capital gain rate. While no tax is the perfect answer, the full capital gain rate of 15% is hardly a confiscatory tax.

If any of these strategies merit discussion with respect to your personal situation, let us know.

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