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Tax-Saving Tips to Consider Before Year Ends
by Mike Scholz

This has been a busy year with a number of recent developments and tax law changes adding new wrinkles to traditional tax planning strategies. Some major highlights of the tax law changes include:

• A new-for-2005 deduction for businesses with “qualified production activities income” was included in the American Jobs Creation Act (AJCA) signed in 2004. The AJCA began as a phase-out of the export subsidy, but eventually mushroomed into a major tax law benefiting most businesses and some individual taxpayers.

• Employers who maintain flexible spending accounts for their employees may be able to soften the effect of the “use-it-or-lose-it” rule this year, but only if they act by December 31, 2005.

• Included in the AJCA were new design and operational requirements for all deferred compensation plans. In many cases, these stricter requirements directly impacted existing deferred compensation arrangements such that failure to comply would result in significant federal income tax consequences. IRS guidance requires certain operational actions be done by December 31, 2005. Plan amendments need to be formalized by the end of 2006.

• With record-high gas prices nationwide, the IRS has raised the mileage reimbursement rate from 40.5 cents a mile to 48.5 cents per mile for all business miles driven from September 1 to December 31, 2005.

These are just a few changes that businesses and individuals need to be aware of as they prepare to make year-end tax moves. Implementing the tax breaks you can use in 2005 versus 2006 is the tricky part. Effective tax planning generally is oriented towards the time-honored approach of deferring income and accelerating deductions to minimize taxes. However, year-end tax planning does not occur in a vacuum. It must take into account each taxpayer’s particular situation and planning goals, with the aim of minimizing taxes to the greatest extent possible. Below are several strategies that businesses and business owners should consider before year-end.

For tax years beginning in 2005 and later tax years, businesses may be eligible for a deduction (also known as the Section 199 deduction) for a portion of their qualified production activities income attributable to domestic manufacturing and other domestic production activities. This new deduction generally has the effect of a reduction in the taxpayer’s marginal rate and, thus, should be taken into account when making decisions regarding income shifting strategies.

Only the qualified production activities described below are eligible for the new Section 199 deduction:

• Manufacture, production, growth or extraction of qualifying production property (i.e., tangible personal property such as clothing, goods or food as well as computer software) by a taxpayer either in whole or in significant part within the United States.

• Production of electricity, natural gas or water in the United States.

• Construction or substantial renovation of real property in the United States, including residential and commercial buildings and infrastructure such as roads, power lines, water systems and communications facilities.

• Engineering and architectural services performed in the United States and relating to the construction of real property.

• Film production, if at least 50 percent of the total compensation relating to the production is for services performed in the United States by actors, production personnel, directors and producers.

In the simplest case, a taxpayer whose entire taxable income is from qualified production activities multiplies that amount by three percent to determine its tentative Code Sec. 199 deduction for the year. In a more complex situation, where only a portion of a business’s activities qualify for the deduction, a taxpayer must segregate qualifying gross receipts from non-qualifying gross receipts and apportion the cost of goods sold and deductions accordingly. In some cases, simplified methods may be used in making this apportionment. In other cases, a taxpayer may have to specifically identify the cost of goods sold and expenses related to qualifying activities.

A taxpayer whose entire taxable income is from qualified production activities multiplies that amount by three percent to determine its tentative Code Sec. 199 deduction for the year.

For 2005, the Section 199 deduction is equal to three percent of the lesser of 1) the business’s total taxable income (adjusted gross income, in the case of a sole proprietor) or 2) the business’s “qualified production activities income” for the year. The deduction is limited to 50 percent of the W-2 wages paid by the business during the calendar year that ends in the tax year. Here again, special computations may be necessary so a professional advisor should be consulted to ensure the maximum deduction is claimed.

New Rules for Non-Qualified Deferred Compensation

The AJCA also ushered in new rules for non-qualified deferred compensation. These arrangements are a promise to pay executives and key employees sometime in the future for services performed currently. The plans are often geared to the individual and based on his or her performance or on the company’s performance.

The AJCA brought new rules, more rules and probably more tax for non-qualified deferred compensation.

Moreover, the definition was broadened to cover more plans and compensation arrangements. The rules apply to compensation deferred after 2004, affecting timing of initial deferral elections, changes to elections, timing of distributions and how benefits are funded. Distributions are allowed only for specific events or after a certain period of time, and payment of benefits generally cannot be accelerated. If a plan fails to meet the requirements, it will result in loss of tax deferral. In addition, all amounts previously deferred will be taxed, plus charged interest and a penalty tax of 20 percent.

These new rules apply to a wide range of non-qualified deferred compensation plans and arrangements, but they specifically exclude 401(k)s and other qualified employer plans, qualified governmental plans and any bona fide plan covering vacation leave, sick leave, compensatory time or disability pay. Non-qualified deferred compensation can still be an effective way to compensate employees. However, you need to determine whether your plans are covered by the new rules and then map out how to bring them into compliance by December 31, 2005. The plan sponsors have been granted until the end of 2006 to make complying amendments, but immediate good faith operational compliance is required this calendar year.

First Year Asset Expensing

For tax years beginning in 2005, the maximum amount of eligible machinery and office equipment (including software) that can be expensed (i.e., deducted in full) under Code Sec. 179 is $105,000, and the expensing deduction does not begin to phase out until the total expensing-eligible property placed in service during the year exceeds $420,000. For 2006, the figures are expected to be around $108,000 and $430,000, respectively. This means that many small- and medium-sized businesses will be able to currently deduct most, if not all, their outlays for machinery and equipment.

What’s more, the expensing deduction is not prorated for the time the asset is in service during the year. This opens up significant year-end planning opportunities. Taxpayers should try to avoid buying and placing in service more than the ceiling amount of expensing-eligible property during the year, if it is possible from the business standpoint to defer additional purchases. As a reminder, the 50 percent “bonus” depreciation provision has now expired and is no longer available for fixed assets purchased after 2004. Section 179 expensing of SUVs is now limited to $25,000 a year unless the vehicle weighs more than 14,000 pounds.

Many small- and medium-sized businesses will be able to currently deduct most, if not all, their outlays for machinery and equipment.

Faster Write-off for Leasehold Improvements

Leasehold improvements on non-residential property are generally depreciated over 39 years. But, the AJCA has shortened this to 15 years for qualified leasehold improvement property placed in service before 2006. The depreciation method is still straight-line, but with the shortened 15-year life. Improvements to the interior of a non-residential building made more than three years after the building was placed in service generally qualify as qualified leasehold improvement property. The improvements can be made by either the lessor or the lessee.

Flexible Spending Arrangements

Cafeteria plans (also known as flexible benefit plans or flexible benefit arrangements) allow employees to pay for health benefits and other qualified benefits with pre-tax dollars. The employee must determine how much he wants set aside from his salary before the beginning of the year. Any amounts not used for qualified benefits incurred before the end of the year are forfeited (i.e., “use-it or-lose it” rule). Employees often try to avoid any forfeiture by incurring qualified expenses late in the year, such as ordering new eyeglasses or contact lenses in December.

However, earlier this year, the IRS announced a significant rule change that allows employers to liberalize the use-it-or-lose-it rule. The IRS will allow companies to give employees an additional two and one-half months after the close of the year to utilize unused amounts. However, there is a possible downside where a health savings account (HSA) is also involved. Because an individual cannot contribute to an HSA while he is covered by an FSA (flexible spending arrangement), if the two and one-half month grace period is treated as coverage under an FSA, an employee would be ineligible to make contributions to an HSA during the extension period.

The new rule permits employers to amend their FSA documents to provide for a two and one-half month grace period following the end of the plan year. Qualified expenses incurred during the grace period may be paid or reimbursed from funds remaining in an employee’s FSA at the end of the prior year.

The IRS says an employer can adopt a grace period for the current plan year (and for subsequent years) by amending the cafeteria plan document before the end of the plan year. Thus, a calendar year plan that wants to extend the deadline for using 2005 FSA contributions until March 15, 2006 must have a plan amendment in place by December 31, 2005.

Special Accounting Rule Defers Employee Recognition of Taxable Fringe Benefits

The value of taxable fringe benefits (e.g., the personal use of a company car) must generally be included in the employee’s income for the tax year in which the benefit is received. However, employers may treat fringe benefits provided in the last two months of the calendar year as having been provided to the employee in the following year. Thus, if the employer makes the election, the employee can defer paying taxes on two months’ worth of benefits received in 2005 until 2006. If an employer uses this rule, it must notify each affected employee between the time of the employee’s last pay check and at or near the time that the Form W-2 is provided.

New Rules on Auto Donations

The IRS has issued guidance on the tougher charitable contribution rules that apply to autos (as well as boats and airplanes) donated after 2004. Under these rules, the deduction for qualified vehicles (motor vehicles, boats and airplanes that are not inventory or held for sale in the ordinary course of business) contributed to charity after 2004 for which the claimed value exceeds $500 is dependent on the charity’s use of the donated property. If the charity sells the vehicle without any “significant intervening use” (i.e., the charity actually uses the vehicle to substantially further its regularly conducted activities, and the use is significant) or “material improvement” (i.e., a major repair or improvement), the donor’s charitable deduction cannot exceed the charity’s gross proceeds from the sale.

The guidance explains these new terms and creates a whole new exception for autos given (or sold at low price) by the charity to needy individuals. Here, the donor may deduct the auto’s fair market value. The guidance also informs donors of what they must do to substantiate their contributions.

Flat-Rate Long-Distance not Subject to Three Percent Excise Tax

The Eleventh Circuit recently held that, contrary to IRS’s view, the three percent federal excise tax on long-distance telephone service does not apply to charges for calls that do not take into account the distance of the call (i.e., non-distance sensitive service). This decision reverses the one court decision that had agreed with the IRS. In addition, bills repealing this excise tax have been introduced in both houses of Congress. Because of this, there is some speculation that IRS may soon abandon its position.
New Hybrid Vehicles Certified for Clean Fuel Deduction

IRS has certified the 2006 model year Lexus RX 400h and Toyota Highlander Hybrid as being eligible for the clean-burning fuel deduction. The original owner of one of these vehicles may claim a deduction of $2,000 for the year that the vehicle is first put into use. The IRS had earlier certified the following model year 2005 hybrid gas-electric automobiles as being eligible for the clean-burning fuel deduction: the Ford Escape SUV, Toyota Prius, Honda Insight, Honda Civic Hybrid and Honda Accord Hybrid.

The Energy Act of 2005 also added four new alternative, hybrid and fuel cell vehicle tax credits that are effective for purchases after 2006. If a buyer is considering purchasing a qualified auto before year end, they should consider the tax incentives offered on a 2005 purchase compared to a 2006 purchase.

Katrina Emergency Tax Relief Act of 2005 (KETRA)

KETRA relaxed the limitations on charitable donations for year-end 2005. In the aftermath of Hurricane Katrina, Congress rushed to pass KETRA to provide additional tax relief, most of which, such as waiving penalties for pre-591?2 retirement plan distributions and waiving the floor on deductible casualty losses, are for those directly affected by the disaster. Other provisions, which relate to charitable giving, have broader applicability.

While the planning ideas presented in this article may be a helpful resource, this is not all-inclusive and not a substitute for consulting a professional tax adviser. The best way to formulate and implement a tax plan that helps you achieve your overall financial objectives is to work with a trusted adviser.

The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting or tax advice or opinion provided by Clifton Gunderson LLP to the reader. The reader also is cautioned that this material may not be applicable to, or suitable for, the reader’s specific circumstances or needs, and may require consideration of non-tax and other tax factors if any action is to be contemplated. The reader should contact his or her Clifton Gunderson LLP or other tax professional prior to taking any action based upon this information. Clifton Gunderson LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.

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