Michael Gray, CPA's Tax and Business Insight

December 12, 2005

© 2005 by Michael C. Gray

ISSN 1539-395X

A monthly report to help you prepare for your financial future, keep more of what you earn by minimizing your taxes, and build an extraordinary business!

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Happy Holidays!

Another year is rapidly coming to a close.

Janet and I are especially excited because we will be having our 1-year-old grandson, Kyan, spend Christmas Eve at our home. We're planning a little visit to Santa on the way, and hope the experience isn't too frightening for the little fellow.

We hope you and your family have reasons to celebrate this holiday season, and wish you a Happy New Year.

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It's time for year-end planning.

Less than one month left in the year. Considering the holidays, the times available for year-end planning consultations will be limited. Why not call for your appointment now? Michael Gray's telephone number is 408-918-3161.

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Our office will be closed to celebrate the holidays.

Our office will be closed on Friday and Mondays, December 23, 26 and January 2. (Michael Gray will also be out of the office for a tax update on December 16.)

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Review your estimated tax and withholding status.

Remember to review your estimated and withholding status for 2005. For non-corporate taxpayers the final estimated tax payment is due January 16, 2006. For corporations, the final estimated tax payment is due December 15, 2005.

Consider consulting with a tax advisor to review your estimated tax and withholding status, and to estimate the amount that will be due with your 2005 income tax returns.

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Should you prepay your state income tax and real estate tax?

More and more taxpayers are finding they are subject to the alternative minimum tax. State income taxes and real estate taxes are not deductible for the alternative minimum tax, so you might not receive a federal tax benefit from prepaying the tax by the end of the year.

In order to find out the answer, the computations have to be made for your particular facts.

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Special opportunity for big federal charitable deductions for individuals expires December 31, 2005.

Part of the Federal legislation for Katrina relief will allow charitable contribution deductions for cash donations beginning on August 28, 2005 and ending December 31, 2005 without applying the usual 50% of adjusted gross income limitation. In addition, these donations will not be phased out based on adjusted gross income levels. Some taxpayers see this as an opportunity to donate proceeds from their retirement accounts when they are over age 59 1/2. California has not adopted this rule. If you are charitably inclined, you should definitely discuss this tax break with your tax advisor.

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Standard mileage rate for 2006 decreases.

The IRS has announced the standard mileage rates for 2006 will decrease. Remember the rates were previously increased for the end of 2005 because as Hurricane Katrina relief from increasing fuel prices, that have since fallen. The amounts per mile are 44.5¢ for business mileage, 18¢ for medical or moving, and 14¢ for charitable mileage, other than for Hurricane Katrina relief. The standard mileage rate for Katrina relief efforts is 70% of the business mileage rate or 31.1¢ per mile for 2006.

The 2005 rates per mile before September 1, 2005 were 40.5¢ business, 15¢ medical or moving, 14¢ charitable.

The 2005 rates per mile after August 31, 2005 were 48.5¢ business, 22¢ medical or moving, 14¢ charitable.

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Time may be running out for non-qualified deferred compensation transitional rule.

The tax laws for non-qualified deferred compensation plans were radically changed by the American Jobs Creation Act of 2004, enacted on October 22, 2004. Provisions of the Act can impose a 20% penalty tax when the plan doesn't meet the new requirements, which probably would significantly postpone the time the funds can be withdrawn. In addition, the taxability of income for some plans may be accelerated, even when it isn't distributed.

Under a transitional rule, amounts withdrawn relating to a termination of a non-qualified deferred compensation plan by December 31, 2005 will not be subject to the penalty tax.

This is a highly complex area that we hope you are already consulting with your tax advisor about, if it applies to you. If you haven't, please do so immediately.

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Correction - tax break for long-term capital gains of low-income taxpayers is limited.

Readers of this newsletter have previously asked about the application of low tax rates - 5% for 2005 through 2007 and 0% for 2008, for long-term capital gains and qualifying dividends (including any taxable gain for the sale of a residence) when a taxpayer is in the 10% or 15% federal tax bracket. This benefit is very limited. Only the long-term capital gain representing the excess of the long term capital gain to the maximum income for the 15% tax rate bracket is eligible for the lower rate. For 2005, the ceiling for the 15% bracket is $29,700 for single individuals and married, filing separately, $59,400 for married, filing jointly, and $39,800 for heads of household. (See the Schedule D Tax Worksheet.)

For example, Janice Smith, who files as a single individual, has a total of $100,000 of taxable income for 2005, of which $75,000 is a long-term capital gain. She had no qualifying dividends. That means $100,000 - $75,000 = $25,000 is taxable income attributable to other sources. $25,000 is taxable at the "regular" tax rates for ordinary income, which would be $3,393. $29,700 - $25,000 = $4,700 is taxed at a 5% long-term capital gains tax rate, or $235. $75,000 - $4,700 = $70,300 is taxed at the 15% long-term capital gains rate, or $10,545. The total tax would be $3,393 + $235 + $10,545 = $14,173.

Low bracket taxpayers shouldn't plan on a big windfall for long-term capital gains for 2008 - just a small tax benefit. Sorry for any mix-up.

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Brace yourself for dependent and filing status changes for 2005 income tax returns.

Some taxpayers will be stunned (or make mistakes) when their 2005 income tax returns are prepared. The Working Families Tax Relief Act of 2004, enacted October 4, 2004, included significant changes relating to the definition of a dependent child and qualification for head of household filing status.

The changes to "definition of a child" are very complex. The emphasis is being shifted from support of the child to the residence of the child. This means that some taxpayers who formerly claimed dependent children who are residents of Canada or Mexico but are not living with the taxpayer will no longer qualify as dependent children. (This is only scratching the surface of this change.)

In addition, single parents who used to qualify to file as a head of household because their adult children (over age 18 or a full-time student over age 23) live with them will no longer qualify when the children have more income than the exemption amount ($3,200 for 2005).

With these changes, some taxpayers will see a big increase in their tax bills for 2005.

California has also adopted these changes.

If you think these changes apply to you and you haven't already planned for them, consider consulting with your tax advisor to prepare now for the tax increase due on April 15.

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No tax discount allowed for Decedent's IRAs.

The Tax Court has rejected an argument that the value of IRA accounts for a decedent's taxable estate should be reduced by income tax liabilities that would be payable when the accounts were distributed. The court also rejected a discount for lack of marketability. The tax adjustment to reduce the effect of double taxation of retirement benefits is the income tax deduction of estate tax on income with respect of a decedent. (Estate of Kahn v. Commissioner, 125 T.C. No. 11 (11/17/05).)

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IRS issues guidance for S corporation family shareholder election.

The IRS has issued guidance on the election to allow members of a family to be treated as a single shareholder. Most importantly, the election is not automatic, a written notification to the IRS is required. (Notice 2005-91, 2005-51 IRB.)

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Six-month automatic filing extension allowed for 2005 Form 1040.

The IRS has changed its procedure so that taxpayers may now apply for a six-month automatic filing extension. Previously a second extension had to be applied for after four months. (IR-2005-131 T.D. 9229, NPRM REG 144898-04.)

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California now allows Unitrust conversions.

California has enacted enabling legislation permitting a trustee to convert a trust to a 3% to 5% unitrust without a court order. In order to qualify, written notice must be given to the beneficiary that the trustee intends to convert the trust, and no beneficiary may object to the conversion. Trustees should consult with their tax and legal counsel about the advisability of making this election. (S.B. 754, (7/21/2005).)

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IRS audit collections up.

IRS Commissioner Mark Everson has reported that, as a result of increased audits of high-income taxpayers, corporations and small businesses, the IRS obtained a record $47.3 billion in enforcement collections.

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Federal deficit swells.

The Federal comptroller general has warned the White House and the U.S. Congress that unfunded liabilities of the federal government are growing out of control. Meanwhile, Congress is negotiating legislation to extend expiring tax cuts.

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Questions and Answers

Dear readers:

Many of your questions relate to the sale of a principal residence. We have an article at our web site, "Could your residence be the ultimate tax shelter?" (taxtrimmers.com/residence.shtml) where you should be able to find the answers to most of these questions.

Question

My wife and I have lived in our house just under 2 years. I've been offered a ministerial position that offers housing free of charge. We stand to make between $30,000 and $40,000 on the house in equity. Will we have to pay a capital gains tax?

Answer

I'm only going to discuss the federal tax law in this response. If you wait to sell the home until after you have lived in it more than two years, you will qualify for a $500,000 exclusion, and no tax will result. Since you are moving relating to a change in employment (and assuming you are moving some distance), you should also qualify for a pro-rated exclusion because of your change in circumstances.

Question

I will be turning 70 1/2 next year and my wife will be 69. We each have a small IRA ($135,000 in total) that we would like to use to establish an endowment at our local community foundation. What are the tax consequences of doing this? Also, is it better to liquidate the accounts and send a check to the foundation or to give the IRAs directly to them?

Answer

There is a special rule in effect for cash donations made at the end of 2005 that will enable you to deduct your entire donation on your federal income tax return, provided you itemize your deductions. The donation will probably be more limited on your state income tax return. See the article, "special opportunity..." above.

Retirement plan proceeds can't be given directly to a charity during your lifetime, so you will have to take the distribution first. Discuss this matter with the community foundation before you go ahead, but don't dawdle - the tax break expires at the end of 2005.


Michael Gray regrets he can no longer personally answer email questions. He will answer selected questions in this newsletter.

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If you have employee stock options, have you subscribed to Michael Gray, CPA's Option Alert?

To learn more, visit stockoptionadvisors.com/subscribe.shtml.

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Visit our new article!

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P.S.

My daughter and her husband, Holly and Dan Baker, have a Southern French Restaurant at 23 Ross Common, Ross, California, about 15 minutes north of the Golden Gate Bridge. The name of the restaurant is Marché Aux Fleurs and their website address is http://marcheauxfleursrestaurant.com. For the best meal of your life, call 415-925-9200 for a reservation and give them a try! For directions, visit our website at http://www.taxtrimmers.com/directions.shtml.

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P.P.S.

To receive the next issue of Michael Gray, CPA's Tax & Business Insight with more tax developments, another book review, and upcoming deadlines automatically via email, subscribe by filling out the form below.

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IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this communication was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.

The December 2005 issue of Michael Gray, CPA's Tax and Business Insight.

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Michael Gray, CPA
2190 Stokes St. Ste. 102
San Jose, CA 95128
(408) 918-3162
FAX: (408) 998-2766
Hours: 8am - 5pm PDT Monday - Friday

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