Tax Surprises In Iraq Spending Bill

On May 25, the President signed the an Iraq war-funding bill. Look closely. Congress couldn't resist tacking on a few tax provisions.

Kiddie Tax To Age 24.
One year ago, the "kiddie tax" was extended from age 14 to age 18. In 2008, it will affect students up to age 24!

The "Kiddie Tax" Idea.
To catch parents who move income into a child's lower bracket, there's a special rule. A youngster with investment income 'Over $1,700 is taxed at the higher of the tax rate of the child or the parent. Income from a job is not affected.

In the year the youngster reaches age 18, the rule does not apply. Few families can afford to sock away enough money to generate this much investment income for a youngster. But, for those who can afford it, this rule is a big problem.

Target 2008.
Here's the latest plan to collect extra tax from middle and high-income families. Next year brings the lowest capital gains rates in history. We currently have five tax "brackets". Find your taxable income, and use these rates:

Long-term capital gains get lower rates. The lower rates also apply to dividends of domestic corporations. This type of income acts as if it "floats" at the top of the taxable income pile. Any capital gain income falling in 25% or higher brackets is taxed at 15%. Long-term capital gain falling in the normal 10% or 15% brackets is taxed at 5%. Sound good? Wait until next year! For 2008,2009 and 2010 the rate on that 10% or 15% layer drops from 5% to ZERO! Not one penny of tax!

Trap! More "Kiddies" Next Year.
Families who can afford to save for college banked on using that 0% tax rate for help. Transfer stocks to the youngster. Let the youngster sell to pay college costs - with no loss to income tax. Congress has shot down this plan. For 2008 and on, dependents between age 19 and 23 who are full-time students will be considered "kiddies". Their long-term gains will be taxed at the higher tax rates of the parents. The only way to avoid the rule is to show the youngster has enough W -2 income to cover more than half his/her support costs. Not likely.

Expensing Business Equipment.
A business normally must depreciate equipment. Small businesses can choose to write off limited amounts of equipment. This applies for up to $112,000 of equipment, but only if the business spent less than $450,000 on new equipment. Congress just raised the $112,000 to $125,000, and raised the total spending cap to $500,000. The rules will be with us (and adjusted for inflation) through 2010. After 2010 we are scheduled to return to the $25,000 limit from 2001 when these changes began.

Break For Mom & Pop Businesses.
When both spouses run a family business, IRS had insisted they file a partnership return, except in community property states. Now Congress says they may simply file a joint return and split the profits equally.

Other Business Items.
The Work Opportunity Tax Credit offers incentives to hire certain groups of workers. The credit was set to expire after 2007, but is extended to those hired before September 1, 2011. Several new categories of workers were added. Several measures for businesses affected by Hurricane Katrina were extended.

Other Measures.
IRS is given more powers to deal with late return filings and erroneous refunds. They also got stiff new penalties for tax practitioners. The new sanctions cover all returns, not just income tax for individuals and businesses. Tougher standards, and larger fines will help IRS crack down on unscrupulous practitioners. I'll be doing more careful research on "gray" areas.

More Laws To Come?
We're likely to see more changes. However, some important items will likely be left for next year. Reform of the Alternative Minimum Tax is still a hot issue, but complicated, and very expensive. The Estate Tax is still unsettled after 2009. We are not likely to see these resolved in 2007.

I Get Questions

Here are a few questions that pop up over and over again.

Q. Roth IRA. I had to take some money from my Roth IRA. I'm only 51 years old. Will there be a tax, or penalty, or both?

A. Perhaps Neither. A Roth IRA has a peculiar "layering" of the dollars within it, much like a cookie jar. The first dollars you take out are deemed to be the ones you contributed. You got no tax break when you contributed, so there is no tax or penalty on these dollars. The second layer of money is any that you "converted" from traditional IRA to Roth IRA. You already paid the tax, and won't be taxed again, but a 10% penalty applies unless the conversion was more than 5 years ago. The bottom layer is the growth money. Take any of these dollars and both income tax and penalty (since you are not yet 5912) will apply.

Q. Closed Business. I shut down my business last year, but paid the last of the expenses this year. May I deduct these?

A. Very Likely! Assuming you were a "sole proprietor" filing Schedule C, we'll simply file another Schedule C and deduct the expenses. If your business was a partnership or corporation things are more involved, but we'll still get value from your expenses.

Q. Large Medical Gift. I've heard the most I can give to someone this year is $12,000. I just paid $26,000 of my mother's medical expense. Do I have a problem?

A. Nope! You fall under an exception. A gift is limited to $12,000 in any year. There is an unlimited exception for medical expense or school tuitions. The single catch is that the payments must be made to the provider or school rather than to your mother. You may have a small bonus - your mother might qualify as your dependent, but I'll need more information from you.

Q. Charity From Inheritance. My mother passed away this year. I donated her furniture to a local charity. Do I get a deduction?

A. Depends. We need to know who made the contribution. I realize you did this, but who did the furniture belong to? Was it your Mother's estate or trust making the donation? If so, the deduction is not yours. If the furniture was now yours (that is, you inherited it), you may definitely claim a deduction for its fair market value.

Q. Forgot A Stock Sale. I just realized that I forgot to report a small stock sale on my last return. The sale caused a tiny $20 loss. Is it worth worrying about this?

A. We Probably Need To Amend Your Return. The $20 loss is not important. There's another problem. IRS receives Form 1099- B listing "gross proceeds" for any stock sale. Since no sale appears on your return, IRS will say the full amount may be income. If this was a "penny stock" you bought for $50 and sold for $30, we might be OK to ignore it. IRS is not likely to bother you over a possible $30 of income. But, suppose you bought the stock for $10,000, and sold for $9,980. The IRS computer will spot you, and IRS will presume you have an additional $9,980 of income. We can clear this " up, of course. However, you have just given IRS a chance to say "let's take a close look at this return before we send a letter". Bad move! You never want to invite them to inspect your tax return. If your case is like this, I suggest we file an amended return as soon as possible.

IRS Crackdown Coming

The "Tax Gap" - IRS Top Target. Last year IRS concluded a massive study of2001 income tax returns. They wanted to measure the "Tax Gap", the difference between the income tax we actually paid and what we should have paid. Why did this take 5 years? Late in 2001 IRS began the National Research Program (NRP) to study our 2001 income tax returns. They randomly selected 46,000 returns for audit. The audits were thorough and time-consuming. The NRP took 3 years to complete.

$345 Billion Shortfall. The number is indeed large. Consider that in 2001 we paid income taxes of just under a trillion dollars. We should have paid another $345 billion. IRS says we should have paid over one-third more than we did. Why? Clearly, some tax is underreported. IRS says the largest understatements come from self-reported items - no big surprise.

How To Fix It? IRS wants to see more information reporting. They'd like brokers to report gains/loss from stock sales. Even more information on W-2s. Reporting on government contracts. And - - - more and more. They also want stiffer audits and more information on where the errors are most likely to be found.

Tougher Audits. Early this year IRS set up new standards for audits. We can expect more correspondence reviews on items that do not match IRS records. Face-to-face meetings last longer, and auditors demand more and better records. They ask more questions than ever - probing questions aimed at understanding spending patterns and life-style. The only good news here is the total number of face-to-face audits will decline a bit as more time is spent on each case.

Random Audits Return. It's been more than 10 years since IRS was forced to stop a different random audit program. They used results to fine-tune their top-secret computer program to identify items most likely to yield extra tax revenue. IRS did about 2,500 of these special audits each year. They checked every single line on the tax forms. Folks were asked to prove why most lines are left blank! Taxpayers complained the program was too harsh and time-consuming, so Congress shut it down.

They're back. Same goal-learn how well we comply with the system. The new audits are shorter, and focus on one or two areas of the return. To gather enough information IRS needs more audits - 13,000 each year for 3 years. Chances you will see one - 1 in 9,000. We won't know details until reports come in from folks who have faced the new audits. The program is set to begin in October. It probably will be 6-10 months before we hear any real details on what happens at the meetings. Stay tuned.

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