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Tax Questions and Answers |
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Q1.
Can you summarize the estimated tax rules so that I can avoid underpayment
penalties? Q11.
Does the $11,000 limit on 401(k) contributions for 2002 apply per
employer or is it the total allowed per employee? |
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Q. Can you summarize the estimated tax rules so that I can avoid underpayment penalties? |
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Estimated taxes are due if you owed $1,000 or more (after withholdings) on your prior year return. Generally you can avoid the estimated tax penalty if you have paid in (through withholdings and estimated tax payments) at least 90% of the current year tax. If you don't meet this first test, your current year estimates must be at least 100% of the total tax on your prior year return (assuming the prior year return covered all 12 months). The percentage for this exception is increased to 112% for 2002 (110% - 2001) if the adjusted gross income is over $150,000 ($75,000 if married filing separately). If your income fluctuates throughout the year, or if your income unexpectedly changes during the year, you may base the estimate installments on the annualized income method. This method allows for you to avoid a penalty for installment periods during which less income is earned by reducing the required estimated tax payment for such periods. |
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Q. What is the maximum Section 179 write-off allowed for equipment used in business and can a vehicle ever be expensed using this election? |
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The Section 179 maximum limits are as follows (assuming no more than $200,000 worth of equipment was purchased during the year): 1999 - $19,000 2000 - $20,000 2001 - $24,000 2002 - $24,000 2003 - $25,000 This first year write-off applies to business-related equipment placed in service before year-end. The election does not apply to business passenger vehicles which have very limited depreciation deductions allowed. It should be noted, however, that vehicles not classified as passenger (i.e. most SUV's) do qualify for the Section 179 first year write-off. |
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Q. How can an individual that makes quarterly estimated tax payments avoid underpayment penalties even though the installments made are insufficient under current safe-harbor rules? |
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As you know, the IRS likes to get their money as soon as they can and requires an individual to remit taxes quarterly based on a number of safe-harbor rules (i.e. prior year tax, current year taxable income). When an individual misses an installment, is late in paying an installment, or has not paid in the proper amount of tax (in one or more quarters) based on current or prior year income, the estimated tax penalties will apply. The penalty for each quarter, which is based on prevailing interest rates, runs from the installment due date until the amount is paid or until the regular filing date for the final tax return, whichever is earlier. The only way to keep the IRS happy is to have withholding from any source (i.e. payroll, IRA or pension distribution, gambling winnings). Withheld taxes are considered by the IRS as having been received evenly throughout the year regardless of when they are actually paid to the IRS. Obviously, the sooner an individual knows they are "short" on their estimates, the sooner additional "withholding planning" can be implemented. |
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Q. From the tax stand point, which generates a larger deduction, leasing or purchasing a vehicle? |
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While there are economic lease vs. buy comparisons that determine the most cost effective way to own a vehicle from a cash flow stand point, little attention is given to the tax advantages of leasing a passenger vehicle. The Tax Reform Act of 1984 drastically reduced the amount of depreciation deduction allowed for luxury passenger vehicles used in business. Currently (for 2001) the maximum deductions available for non-electric luxury vehicles are $3,060 - first year, $4,900 - second year, $2,950 - third year, $1,775 each year thereafter until fully depreciated. By contrast, the deduction for a leased vehicle is 100% of the lease cost less a relatively small add-back (Income Inclusion Amount) that "attempts" to reduce the lease deduction to the same level as depreciation. In most cases, the deduction for the leased vehicle will far surpass the deduction for depreciation. An exception to this general rule is available for those vehicles not classified as "passenger automobiles". See following FAQ that provides the definition. |
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Passenger vehicles with an enclosed body built on a truck chassis, plus vehicles commonly known as minivans or sport utility vehicles (SUV's), are not passenger autos if they have a gross vehicle weight rating - the manufacturer's maximum weight rating when loaded to capacity - above 6,000 pounds. Passenger vehicles that meet this definition can be depreciated under the relatively generous rules that apply to heavy trucks and vans rather that under the very unfavorable rules that apply to passenger autos. Vehicles that are heavy enough to escape passenger auto classification are also exempt from the IRS lease add-backs that apply to "luxury" passenger autos as long as they are used more that 50% of the time for business purposes. Following are a number of vehicles that are not considered passenger vehicles (source www. intellichoice.com): AM
General Dodge
Ford
GMC Land
Rover Lexus
Lincoln
Mercedes
Toyota
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Q. What is the alternative minimum tax and how does it relate to planning for exercising incentive stock options? |
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The Federal income tax is actually a parallel tax system. There is a "regular" tax that most of us are fairly familiar with. There is also an "alternative minimum tax" (AMT). Your tax is computed using both methods, and you generally pay the higher tax. If the alternative minimum tax does apply, a portion of the excess over the regular tax may be available as a tax credit in a later year, treated somewhat like a prepayment of the later year's tax. The alternative minimum tax rates are 26% for the first $175,000 of alternative minimum taxable income (AMTI) and 28% for AMT income over $175,000. Single persons have an AMT exemption of $35,750, phased out by 25% of the excess of AMTI over $112,500, and eliminated for AMTI of $255,500 or more. The AMT exemption on a joint return for married persons is $49,000, phased out by 25% of the excess of AMTI over $150,000, and eliminated for AMTI of $346,000 or more. The alternative minimum tax is a critical concern relating to ISOs. The excess of the fair market value on the date of exercise over the option price is considered a "tax preference" that is added to regular taxable income in computing the alternative minimum taxable income (AMTI) for the year of exercise. Note the new rates for long-term capital gains do not apply to this "spread" amount. Considering major deductions are disallowed for AMT, including state income taxes, property taxes and most miscellaneous itemized deductions, and a maximum AMT tax rate of 28% (even considering the reduced rates applying for long-term capital gains), it is quite common for the AMT to apply in the year of exercise of an ISO. If the employee sells the shares acquired using the ISO in the year of exercise, there is no AMT because the spread between the fair market value on the date of exercise and the option price is reported as compensation income or a short term gain for regular tax reporting purposes. |
| Q. In 2000, we exercised some incentive stock options at $7/share (with a market price of $30/share) and ended up paying AMT for the 2000 tax year. Since then, the shares have fallen to $10. What can we do? |
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If you sell the shares now (2002) for $10, you will unfortunately have a regular tax gain of $3 a share. The regular tax gain will be capital or ordinary income, depending on whether your sale is a disqualifying disposition. At the same time, you will have an AMT loss of $20 a share ($30 AMT basis equal to market value on the exercise date less $10 sale price.). This would show up as a "negative adjustment" of $23 a share on your 2002 Form 6251. If you paid AMT in 2000 when you exercised the options, you hopefully generated an AMT credit (see Form 8801). If so, you would probably be able to use any remaining credit against your 2002 regular tax if you sell this year. If you did not actually own any AMT for 2000, the fact that you had a positive adjustment on that year's Form 6251 didn't actually cause you to pay any additional tax, and this year's sale of the option shares for an AMT loss won't do you any good unless you owe 2002 AMT for other reasons. |
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Q. If I think I might be close to paying AMT, is there anything I can do to reduce my exposure? |
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It's difficult to "plan around" the AMT. The applicable Code Sections were cleverly drafted to prevent moves that are effective in reducing taxpayers' regular tax liability from also reducing their AMT. For example, a regular tax planning maneuver that's a terrible idea for AMT victims is the time-honored advice to prepay state and local income and property taxes before year-end. Prepayment generates a bigger regular tax write-off, but the deduction is completely disallowed in computing the AMT. So prepayment could turn an expense that might have generated a tax benefit for the client next year into an expense that will never generate any tax benefit. Another good regular tax planning idea that won't help AMT victims is using home equity loan proceeds to pay off other debts that generate nondeductible "consumer interest." For AMT purposes, home equity loans generate deductible interest only when the proceeds are used for buying, building, or substantially improving the client's first or second residence (or when the home equity loan is used to refinance another loan, the proceeds of which were used for such expenditures). Of course, the AMT-prone client still comes out ahead economically if he or she can take out a low-interest home equity loan and pay off debts that charge higher interest rates. Of course the most likely cause of big AMT liabilities these days occurs when exercising incentive stock options (ISOs). Clients with ISOs should consider the following AMT avoidance strategies: Exercise the ISO early when the spread between market value and exercise price is minimal. Unfortunately, this strategy requires coming up with the cash to exercise, and it will turn out to be an awful idea if the stock subsequently declines in value. If there is already a substantial spread, it's too late for the "exercise early" strategy. Now the best scheme may be to "stagger" the exercise dates so they fall in several different tax years. The idea here is that staggering may keep the spread recognized for AMT purposes in any one year to a level that won't trigger the AMT. However, this strategy isn't available when the client's options are about to expire. Plus it could be counterproductive if the stock continues to appreciate, because the 'deferred spread" will keep getting bigger and bigger. On the other hand, the client could get lucky and see Congress reform the AMT rules or even repeal the tax altogether (wouldn't that be nice). Then deferring the exercise date would look really smart. |
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Q. I know that investment losses on normal IRA's aren't deductible but what about investment losses I have incurred in my non-deductible IRA account? |
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Since you received no deduction for your IRA contribution you have a tax basis equal to your contributions. If you liquidate a non-deductible IRA for less than your basis you have a deductible loss that can be claimed as a miscellaneous itemized deduction that is subject to the 2% AGI floor. |
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Q. Can I withdraw my retirement funds to pay for my children's college costs without incurring the 10% early distribution penalty if I am not yet 59 1/2? |
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Only the IRA rules allow you to do this. The 10% penalty will apply to distribution from other qualified plans (i.e. 401(k)). In any event, the amount that is withdrawn is subject to income tax. |
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Q. Does the $11,000 limit on 401(k) contributions for 2002 apply per employer or is it the total allowed per employee? |
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The 401(k) maximum contribution limits apply per individual. If you have more than one employer during the year, you must be sure to not go over this limit to avoid excess deferral penalties. There is no such penalty if you correct the situation by April 15. |