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Michael Gray, CPA's Tax and Business Insight

November 22, 2006

© 2006 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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Table of Contents

• Happy holidays!
• Vacation report.
• Not much time left for year-end planning!
• Money on sale! Set up an equity line of credit now.
• Year end planning reminders.
• Watch year-end business payments.
• Watch accrued compensation for employees and independent contractors.
• About the election results.
• Per diem allowances must be substantiated or included on W-2.
• Temporary regulations issued explaining W-2 wages for domestic production activities deduction.
• Retirement plan limit increases for 2007.
• Social Security wage base increases.
• New standard mileage allowance.
• Questions and Answers
• Sale of principle residence answers.
• Can I take money from my IRA to pay home building costs?
• What is the penalty for not filing form 3115 by the due date?
• Can I claim a charitable deduction for groceries I donate?
• Can we get an exclusion on a home we could never move into?
• Can I claim my girlfriend's children as dependents?
• Do you have employee stock options?
• Do you have real estate tax issues?
• PS Marché Aux Fleurs
• Subscribe to Michael Gray, CPA's Tax & Business Insight

Happy holidays!

We wish you and your family a joyous holiday season! Make it a safe one.

We are issuing the final newsletter for 2006 early because Dawn will be out of the office after today until December 18.

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Vacation report.

Janet and I had a great vacation in the Southeast. We stayed at a resort community, Edisto Island, in South Carolina. We visited Charleston, Beaufort, and Savannah, including the Magnolia Plantation, which has been converted to a historic park and wildlife sanctuary. We saw lots of alligators at the Magnolia Plantation, and dolphins at Edisto Island and Charleston.

These places have been popular movie locations, including for Forrest Gump and The Great Santini.

The architecture for buildings close to the east coast is interesting because most of them are built on stilts for protection against water damage from storms. The biggest recent storm was Hurricane Hugo in 1989.

Did you know that Savannah is the birth place for the Girl Scouts?

We took a ghost tour of Savannah, which claims to be the most haunted city in the U.S.

Thi Nguyen and her husband Allen Le vacationed in Cancun. They spent most of their time relaxing at the resort.

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Not much time left for year-end planning - make your reservation now!

Thi and I have a number of activities coming up. We will be at a Dan Kennedy program on December 1 and 2 and tax update classes on December 18 and 19, and Christmas is Monday, December 25. Our office will also be closed on Friday, December 22.

That leaves a very limited calendar for tax consultations. If you need a tax consultation appointment, call Thi Nguyen at 408-918-3163 or call me at 408-918-3161 to reserve your time now.

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Money on sale! Set up an equity line of credit now.

There are some great opportunities for below prime rate home equity lines with no fees. We think this especially worth considering for seniors, and is almost always a superior alternative to reverse mortgages. To discuss this further, call me at 408-918-3161.

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Year end planning reminders.

If you itemize deductions, you can claim 2006 tax deductions for your final California estimated tax payment and the second property tax installment if they are paid by December 31, 2006. Be careful, because these items aren't deductible for the alternative minimum tax, so you could lose your tax benefit. (A good reason to schedule a year-end planning meeting!)

Rules of thumb - match the deduction for California taxes with ordinary income (like wages and interest). Since the tax rate for long-term capital gains and qualifying dividends are the same for the regular tax and the alternative minimum tax, you usually won't get a tax benefit by prepaying the California tax for these items.

If you have big capital gains to report for 2006, consider selling "loser" investments before the end of the year to offset the gains.

If you are age 70 1/2 or older, remember to take your required minimum distributions from IRA accounts and other qualified plan accounts, including 401(k) and profit sharing accounts. Remember you have a special election available for 2006 to have your distribution paid directly to a qualifying charity and avoid tax on the distribution. Be sure to get required documentation from the charity.

Consider making gifts of appreciated property before the year end. Remember that appraisals may be required. (Not required for donations of publicly-traded stock.)

Donations paid using a credit card during 2006 will be deductible on your 2006 income tax return. Be sure to give the charity enough time to process your donation, so don't wait until the last minute.

Remember that interest expense for a margin account isn't deductible unless it is paid, so be sure it was in fact paid and not just added to your margin loan balance. (Sales proceeds applied to an account balance is a "payment".)

Watch your federal and state income tax withholding to be sure it will be sufficient to avoid penalties for underpayment of estimated tax.

These are just a few of the major year-end planning considerations. See your tax advisor relating to your own situation.

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Watch year-end business payments.

Remember that related-party payments must usually be made by the end of the year to be currently deductible, even when the business uses the accrual basis of accounting. This includes salary, bonuses and interest due to controlling shareholders (and their family members) of most corporations, any shareholder of an S corporation and any partner. See your tax advisor for details.

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Watch accrued compensation for employees and independent contractors.

The new deferred compensation rules are very strict and complex. Any payments for accrued wages due to employees and independent contractors should be made by the fifteenth day of the third month after the year end (March 15 for a calendar year business) in order to avoid having it deemed to be deferred compensation and subject to the deferred compensation rules.

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About the election results.

Now that we have a Democrat controlled Congress and a Republican President, it remains to be seen what, if anything, will be accomplished with tax reform and tax break extensions during the next two years. Two major items to be dealt with are the estate tax and the alternative minimum tax.

The estate tax is scheduled to be repealed for one year in 2010 and then be restored to the law before 2001. Most commentators believe that Congress can agree on an increased exemption for the estate tax ($3 million to $5 million) and the one-year repeal will be eliminated.

The alternative minimum tax is a more difficult problem because is generates very significant revenue. I don't expect it to be significantly modified until the next President is elected. Look for temporary increases to the exemption, as we have seen for the last several years.

The IRS has already sent the forms for 2006 income tax returns to the press. Some extensions of tax breaks, including the research credit, will probably be passed, most likely early next year. The 2007 tax season will be a mess, and more tax returns will probably be extended next year than for 2006.

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Per diem allowances must be substantiated or included on W-2.

The IRS has ruled that an employer must include the total amount of expense reimbursements on an employee's W-2 if the employee isn't required to account for the use of the funds and to reimburse the employer for any unsubstantiated amounts. This is the "accountable plan" rule. (Rev. Rul 2006-58.)

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Temporary regulations are issued explaining W-2 wages for domestic production activities deduction.

The IRS has issued temporary regulations explaining how W-2 wages are calculated to determine the wages limitation for the domestic production activities deduction. The rules are very complex, especially when related businesses are involved. See your tax advisor. (TD 9293.)

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Retirement plan limit increases for 2007.

New retirement plan limits have been announced effective January 1, 2007. For defined benefit plans, the annual benefit will be increased from $175,000 to 180,000. The defined contribution plan limit (profit sharing plans and money-purchase pension plans) will increase from $44,000 to $45,000. The maximum deferral for 401(k) and 403(b) plans will increase from $15,000 to $15,500. The maximum deferral for a SIMPLE plan will increase from $10,000 to $10,500. (IR 2006-162.)

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Social Security wage base increases.

The maximum wages subject to Social Security tax will increase from $94,200 in 2006 to $97,500 for 2007. The Social Security tax rate remains 6.2%, resulting in maximum Social Security withholding increasing from $5,840.40 for 2006 to $6,045 for 2007.

There is no limit for Medicare withholding. The Medicare rate remains 1.45%.

The Self-Employment Tax rates are double the rates for wages, or 12.4% for Social Security and 1.45% for Medicare. The maximum Self-Employment Social Security Tax will increase from $11,680.80 to $12,090. (Social Security News Release, 10/18/2006.)

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New standard milage allowance.

The standard business mileage allowance will increase from 44.5¢ to 48.5¢ per mile for 2007. The depreciation component of the mileage allowance will increase from 17¢ per mile to 19¢ per mile.

The standard mileage rate for medical care and moving expenses will increase from 18¢ per mile to 20¢ per mile for 2007.

The standard mileage rate for charitable use will remain at 14¢ per mile for 2007. (Revenue Procedure 2006-49.)

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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?" (realestateinvestingtax.com/residence.shtml) where you should be able to find the answers to most of these questions.

Question

I purchased the land for my first home in the beginning of 2005 and have been building it. I relocated for family matters and have been unemployed for years while helping my parents and building the home.

I have been drawing down my savings. Can I still qualify for the exception from early distribution penalty for withdrawing funds from an IRA?

Answer

It appears you can, providing you are paying for costs you are currently incurring for building the home. The lifetime maximum that you can withdraw for this purpose is $10,000. The payment must be used within 120 days after receiving it to pay qualifying acquisition costs. Qualified acquisition costs include the costs of constructing a new residence. You must use the home as your principal residence after you finish building it. (Internal Revenue Code Section 72(t)(8).)

Question

What is the penalty for not filing Form 3115 by the due date?

Answer

You should meet with a tax advisor relating to your personal situation. The IRS could disallow the change of accounting method and any related tax benefits. You might need to amend the income tax return and pay related penalties for any late payment of tax plus interest.

This could be a mess.

Question

I volunteer for a nonprofit organization. We're having a fundraiser, and I'm cooking dinner for 60 volunteers. Can I claim a charitable deduction for the cost of the groceries I buy to feed the volunteers? I understand I can't deduct my time.

Answer

If the organization is a qualifying charity, you should be able to deduct the cost of the groceries. I suggest that you make an "expense report" for the charity and get a "thank you" letter acknowledging your gift.

Question

We moved 2,000 miles from our home town two years ago because of employment. We were building our principal residence, but never lived in it. Will we qualify for any exclusion on the sale?

Answer

Since you never lived in the residence, it won't qualify as a principal residence and no exclusion will be allowed.

Question

Can I claim my girlfriend's children on my income tax returns? They lived with me all year and she hasn't worked.

Answer

I'm sorry, but since your girlfriend is eligible to claim them as her dependents, you can't. The taxpayer is no longer required to provide more than one-half the support of a dependent child to claim the exemption. In order to qualify to claim the exemptions, you either have to marry your girlfriend or legally adopt the children.

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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 subscribe or review past issues, go to www.stockoptionadvisors.com/optionalert/.

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We are starting a newsletter devoted to real estate tax issues.

Like this newsletter, we will talk about new developments, have reports on special tax concerns, and answer questions and answers. The subscription rate is $19.95 per month. For a sample issue, visit realestatetaxletter.com.

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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.

They also have a second restaurant, AVA, at 636 San Anselmo Ave., San Anselmo, California. AVA serves food and drinks produced in California. For reservations, call 415-453-3407. The web site is avamarin.com.

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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.