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2002 FEDERAL TAX DEVELOPMENTS
Dear Clients and Friends: Over the past several years, taxpayers have been overwhelmed with new tax legislation and other income tax changes which have developed at an unprecedented pace. In 2001, President Bush signed into law the “Economic Growth and Tax Relief Act of 2001" - the most sweeping tax cut legislation in 20 years. Many of the most significant provisions of this mammoth tax bill were not effective until this year (e.g., increased qualified plan deductions, increased adoption credit, new credit for child care facilities, increased education savings account limits, section 529 plan changes, new deduction for higher education expenses, etc.). Last March, Congress enacted the “Job Creation and Worker Assistance Act of 2002" which included a new 30% depreciation deduction, increased depreciation for luxury autos, added new NOL carryback provisions, increased SEP deductions, and created a new deduction for teachers’ expenses. The following article addresses the major tax developments and includes those items we believe affect the largest number of our clients and the general population. If you have heard or read about any recent tax development that is not discussed in this article, please feel free to call our office. We will help you research the matter to determine whether it will have a tax impact on you or your business. We offer planning ideas throughout this article. However, you cannot properly evaluate a particular planning strategy without calculating your overall tax liability (including the alternative minimum tax) both with and without that strategy. We encourage you to call our firm before adopting any tax planning recommendation Very truly yours,
HIGHLIGHTS OF CHANGES IMPACTING PRIMARILY INDIVIDUALS
Job Creation And Worker Assistance Act Of 2002
The Job Creation and Worker Assistance Act of 2002 was signed into law March 9, 2002. Although this legislation was designed primarily to give tax relief to businesses, it also contains several provisions impacting “individual” taxpayers.
Expansion Of Tax-Free Foster Care Payments. If you are receiving payments for providing foster care, and you meet certain requirements, you are entitled to exclude the payments from your taxable income. Effective for taxable years beginning after 2001, this legislation expands the definition of qualified foster care payments to include payments by a placement agency that is licensed or certified by a state or local government, or by an entity designated by a state or local government to make payments to providers of foster care. Thus, payments made by for-profit agencies contracting with State and local governments to provide foster home placements may now be excluded from income by foster care providers. Also, the new law allows foster care providers to exclude payments made by tax-exempt and for-profit placement agencies with respect to foster care individuals who are over age 18 at the time of placement.
New $250 “Above-the-Line” Deduction For Teachers. If you or your spouse teach kindergarten through 12th grade, this change may reduce your tax liability. For 2002 and 2003, if you are an “eligible educator” you will be able to deduct as an “above-the-line” deduction (deductible even if you don’t itemize) up to $250 of your qualified classroom expenses. Your qualified expenses include books, supplies (other than non-athletic supplies for courses in health or physical education), computer equipment (including software and services), other equipment, and supplementary materials. Planning Alert! To be an “eligible educator” you must be a kindergarten through grade 12 teacher, instructor, counselor, principal, or aide working at least 900 hours during the school year.
Economic Growth And Tax Relief Reconciliation Act Of 2001 (And Other Developments)
Last year, Congress passed the “Economic Growth and Tax Relief Reconciliation Act of 2001" - one of the most sweeping tax cut bills in 20 years. This legislation includes the first cut in tax rates since 1986; provides significant child-related tax relief; expands dramatically tax incentives for education expenses; phases out the estate and generation-skipping taxes; and allows larger contributions to IRAs and other retirement plans. Although enacted in 2001, many of the most important provisions in this tax bill are effective for the first time in 2002. Consequently, this is the first year the tax benefits listed below are available.
Expansion Of Adoption Tax Credit. Starting in 2002, the adoption
credit (1) is increased to a maximum of $10,000 per child (up
from $5,000 per child), (2) is made permanent (previously, it was
a temporary credit except for special needs children), and (3) is
not reduced by the alternative minimum tax. If an employer provides a
qualified adoption benefit for employees, the employer exclusion is also
increased to $10,000. Planning Alert! The level
of income at which the adoption credit is phased out has been increased
for 2002. The credit is reduced ratably as your modified adjusted gross
income increases from $150,000 to $190,000 (up from $75,000 to $115,000
in 2001). Education Savings Account Contribution Limit Increased. Starting in 2002, the annual limit for contributions to Coverdell education savings accounts (previously called education IRAs) increased from $500 to $2,000. This allows four times as much to be accumulated for qualified education expenses using Coverdell education savings accounts. This limit applies to the aggregate contributions that may be made by all contributors to one or more education savings accounts established on behalf of a particular child. Tax Tip. Distributions from an education savings account may now be used to finance education for grades K-12 as well as for higher education without triggering income on the distribution.
New Education Expense Deduction. Beginning in 2002, there is a new “for AGI deduction” for college tuition and fees. The maximum deduction for 2002 is $3,000. The deduction is not allowed once your adjusted gross income exceeds $130,000 on a joint return ($65,000 if single).
§529 College Savings Plans. You may now contribute to both a Coverdell education savings account and a section 529 college savings plan (“§529 plan”) for the same student during the same tax year without incurring a penalty (previously there was a 6% penalty). Furthermore, you may rollover (tax-free) amounts from one state’s §529 plan to another state’s plan. Only one rollover is allowed each year. In addition, distributions (including distributions of income) from a §529 plan will be tax-free, beginning in 2002, if used to pay qualified higher education expenses (including room and board). Tax Tip. Today, most states sponsor a §529 college savings plan. Most state plans offer several investment options when you first contribute to the plan. Prior to 2002, you generally could not change investment options after you contributed to the plan. New IRS rules now allow you to switch between the various investment options offered by the plan once a year.
IRS Certifies Deduction For Clean-Fuel Vehicles. If you purchase a “qualified clean-fuel vehicle” (e.g., certain new automobiles, SUVs, pickups, etc. adapted to run on clean-burning fuels) you may be entitled to a $2,000 above-the-line deduction whether or not you use the vehicle in your business. This deduction is available to individuals, sole proprietors, partnerships, LLCs, S corporations, and regular “C” corporations. Good News! The IRS has recently certified the following vehicles as qualifying for this $2,000 deduction: Toyota Prius (for model years 2001, 2002, 2003), Honda Insight (for model years 2000, 2001, and 2002), and Honda Civic-Hybrid (for the model year 2003). It also appears that Ford Motor Co. will have a hybrid version of the Escape SUV that will be certified for the 2003 model year. Tax Tip. Please let us know if you have purchased any of these vehicles during 2002 or a prior year, so we can make sure you get the deduction. Planning Alert! You are not allowed this deduction if you lease the vehicle or if you purchase a used vehicle.
HIGHLIGHTS OF CHANGES IMPACTING PRIMARILY BUSINESSES
Job Creation And Worker Assistance Act Of 2002
This tax bill was signed into law March 9, 2002, and is designed to provide tax relief to businesses in light of the economic downturn and the September 11th terrorist attacks. The following are several of the provisions of the Act that affect businesses.
Additional 30% First Year Depreciation. The new legislation allows your business an immediate 30% deduction of the cost of “qualified property.” To qualify, the property generally must be purchased after September 10, 2001 and before September 11, 2004, and must be placed into service before January 1, 2005. You will be allowed this deduction for both regular and alternative minimum tax purposes. Planning Alert! To qualify for this deduction, you must satisfy the requirements summarized below:
Additional First Year Depreciation On Passenger Automobiles. The maximum first year depreciation for business automobiles is normally $3,060 for 2002. However, for passenger automobiles purchased after September 10, 2001 and before September 11, 2004, the first year depreciation cap is increased by $4,600 ($13,800 for electric autos) if the additional 30% depreciation is taken for the auto. Consequently, the maximum first year depreciation on a qualifying passenger automobile for which the 30% additional depreciation deduction is taken for 2002 is $7,660 ($3,060 plus $4,600). Tax Tip. Vans and trucks (including SUVs) are exempt from the depreciation limitations for passenger autos if the vehicle’s “gross vehicle weight” exceeds 6,000 pounds (e.g., full-size van, full-size pickup, Expedition, Range Rover, Tahoe, Durango, Suburban). To the extent of the business use percentage, these vehicles may qualify for the §179 deduction, the new 30% first year depreciation deduction, and the regular depreciation deduction without applying the $7,660 cap.
Economic Growth And Tax Relief Act Of 2001 (And Other Developments)
As we discussed previously, the 2001 Act focused primarily on tax relief for individuals. However, the Act also contained several important tax relief provisions for businesses. The following are a few of those provisions.
New Tax Credit For Employer-Provided Child Care Facilities. Starting in 2002, your business may qualify for a new tax credit of up to $150,000. The credit equals 25% of a business’ “qualified expenses for employee child care” plus a 10% credit for “qualified expenses for child care resource and referral services.” If you operate a child care facility for your employees, the 25% credit applies to the costs of operating the facility as well as costs incurred to acquire, construct, rehabilitate or expand the facility. Also, the 25% credit is available for costs incurred under a contract with a qualified child care facility to provide child care services to employees. Caution! The requirements for this credit are complex. If you think you may qualify for this credit, we will gladly help you with the details.
Retirement Savings And Pension Reform. This year marks the first year for many pro-taxpayer changes to retirement plan benefits. These changes impact regular IRAs, Roth IRAs, SIMPLE plans, 403(b) tax deferred annuities, section 457 plans and employer-sponsored retirement plans. The changes are far too complex to discuss completely in this letter. We have highlighted below the provisions we believe have the broadest impact. Many of the contribution limitations, etc. discussed below continue to increase for the next several years.
· Increased Qualified Retirement Plan Contributions And Benefits. This year, the deductible employer contribution limitation for defined contribution plans (e.g., profit-sharing plans) is increased from 15% to 25% of the compensation of employees covered under the plan. Also, the maximum annual addition for any one year (the sum of employer contributions, employee contributions and forfeitures) to anyone’s account in a defined contribution plan is increased to the lesser of 100% (up from 25%) of compensation or $40,000 (up from $35,000).
Tax Tip. Prior to 2002, if your company wanted to contribute the full 25% of covered employee compensation to a qualified defined contribution plan, you had to adopt both a profit-sharing plan and a money-purchase plan. For years beginning after 2001, the entire 25% contribution may be made to a profit-sharing plan alone. In most cases, your company will have more flexibility in determining the amount of each year’s contribution and could possibly save administrative costs by maintaining only a single profit-sharing plan. The IRS has recently announced that a money-purchase plan may be merged into a profit-sharing plan without causing an immediate 100% vesting of the money-purchase plan participants. This makes it even easier to eliminate an existing money-purchase plan. Planning Alert! Before merging or terminating any qualified retirement plan, please consult with us and your attorney.
New “Safe Harbor” For Cash Method Taxpayers. In recent years, the IRS has taken an aggressive position against certain cash method businesses, arguing that they should switch to the accrual method. The IRS generally argued that your business should convert to the accrual method if it utilized inventory, or abused the cash method (e.g., unnecessarily deferring revenues or accelerating expenses). After losing a series of cases on this issue, the IRS released a revenue procedure allowing “qualified small businesses” to use the cash method of accounting even if inventories are significant. To qualify, the average gross receipts of the business for the past three years must be $1 million or less. Good News! This year, the IRS released a second safe harbor allowing “qualified taxpayers” to use the cash method even if their average gross receipts for the preceding three years exceed $1 million as long as the average gross receipts do not exceed $10 million. Planning Alert! With some exceptions, manufacturing, wholesale, retail, mining, and publishing businesses, may not use the $10,000,000 rule. However, most service businesses will qualify. Also, under both the $1,000,000 and the $10,000,000 rule, inventories may not be expensed until the later of (1) the date payment is made for the goods or (2) the date the goods are sold or consumed in the business. Tax Tip. If your business is currently reporting its taxable income using the accrual method, and you believe the business may qualify for either the $1 million or $10 million safe harbor, please call us. We will determine whether your business qualifies and whether the switch will reduce your taxable income. We will also help you apply to the IRS for a change in accounting method.
FINAL COMMENTS
Please call us if you are interested in a tax topic that we did not discuss. Tax law is constantly changing due to new legislation, cases, regulations, and IRS rulings. Our firm closely monitors these changes and will be glad to discuss any current tax developments and planning ideas with you. Please call us before implementing any planning ideas discussed in this letter, or if you need more information.
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2002 Tax Developments
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