2010 Year-End Tax Planning for Individuals - Part 1

Click here to read 2010 Year-End Tax Planning for Individuals - Part 2.

Individual income taxes, whether paid through employer withholding or quarterly estimates, are probably one of your largest annual expenditures. So, just as you would shop around for the best price for food, clothing or merchandise, you want to consider opportunities to reduce or defer your annual tax obligation.

This Tax Letter is intended to assist you in that effort. Also, at the end of this Tax Letter is a list of federal tax law provisions to help individuals save and pay for higher education costs.

Although Congress enacted several tax bills throughout 2010, the most significant tax legislation of the year was enacted in the waning days of the 111th Congress. President Obama recently signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the “2010 Tax Relief Act”), providing for a two-year extension of the individual tax rate structure, including the maximum tax rates on qualified dividends and long-term capital gains; a one-year reduction in the OASDI share of the FICA and self-employment tax rates; a two-year extension of the research and development tax credit; and additional temporary investment incentives. The enactment of the 2010 Tax Relief Act removes—for the next two years—the uncertainty that has affected most taxpayers in recent years, as tax cuts enacted in 2001 and 2003 were otherwise due to expire at the end of this year.

In addition to the income tax planning implications of the expiring income tax provisions, 2010 has been a unique year for wealth transfer taxes as well. Prior to the enactment of the 2010 Tax Relief Act, there was no estate tax and no generation-skipping transfer tax. The maximum gift tax rate is 35 percent. Pursuant to the 2010 Tax Relief Act, the estate tax will be imposed for decedents dying in 2011 or 2012 with a maximum tax rate of 35 percent and an exclusion of $5 million. That exclusion is “portable,” such that any unused portion of the exclusion of a spouse who is the first to die may be used by the estate of the surviving spouse at the time of that spouse’s subsequent death. For decedents dying in 2010, the executor of the estate may elect to be subject to the estate tax (at 2011 rates and exemptions) or the modified carryover basis rules.

Your 2010 year-end tax planning begins with a projection of your estimated income, deductions and tax liability for 2010 and 2011. You should review actual amounts from 2009 to assist you with these projections. To the extent you can control the timing of income and deductions between 2010 and 2011, you should make decisions that will result in the lowest overall tax for both years. If shifting income and deductions between 2010 and 2011 does not reduce your overall tax liability, you should try to defer as much tax liability as possible from 2010 to 2011.

Tax planning for individuals also requires consideration of the tax consequences to any businesses conducted directly or indirectly by the individual owners. Accordingly, we suggest you also review our December Tax Letter entitled Year-End Tax Planning for Businesses. This Tax Letter discusses planning for federal income taxes. However, state income taxes should also be considered. Your BDO USA, LLP or BDO Seidman Alliance* firm client service professional can be consulted regarding state tax matters.

* The BDO Seidman Alliance is a nationwide association of independently owned local, regional and boutique firms.

2010 Versus 2011 Marginal Tax Rates

Whether you should defer or accelerate income and deductions between 2010 and 2011 depends to a great extent on your projected marginal (highest) tax rate for each year. After giving effect to the 2010 Tax Relief Act, the highest marginal tax rates for 2010 and 2011 are 35 percent in each year. The tax brackets for 2010 are shown in the box below. Projections of your 2010 and 2011 income and deductions are necessary to estimate your marginal tax rate for each year.

Shifting Income and Deductions Into the Most Advantageous Year

You can shift taxable income between 2010 and 2011 by controlling the receipt of income and the payment of deductions. Generally, income should be received in the year with the lower marginal tax rate, while deductible expenses should be paid in the year with the higher marginal rate. If your top tax rate is the same in 2010 and 2011, deferring income into 2011 and accelerating deductions into 2010 will generally produce a tax deferral of up to one year. On the other hand, if you expect your tax rate to be higher in 2011, you may want to accelerate income into 2010 and defer deductions to 2011.

Planning Suggestion: You should consider the time value of money when making a decision to defer income or accelerate deductions. Comparative computations should be made to determine and evaluate the net after-tax result of these financial actions.

Moreover, you should consider whether you expect to be subject to the alternative minimum tax (“AMT”) for either or both years.

Controlling Income

Income can be accelerated into 2010 or deferred to 2011 by controlling the receipt of various types of income depending on your situation, such as:

For Business Owners

• Year-end interest or dividend payments from closely-held corporations;
• Rents and fees for services (delay December billings to defer income); and
• Commissions (close sales in January to defer income).

Caution: Income cannot be deferred to 2011 if you constructively receive it in 2010. Constructive receipt occurs when you have the right to receive payment or have received a check for payment even though it has not been deposited. Income also cannot be deferred if you effectively receive the benefit of the income; for example, if you are allowed to pledge a deferred compensation account balance to obtain a loan.

Bonuses for work performed in a particular year can be deferred to the next year if an election is made no later than the end of the year preceding the year the work is to be performed. Accordingly, bonuses for work to be performed in 2011 can be deferred to 2012 if the required election is made before the end of 2010.

2010 Federal Income Tax Rates

For Investors

• Interest on short-term investments, such as Treasury bills (“T-bills”) and certain certificates of deposit that do not permit early withdrawal of the interest without a substantial penalty, is not taxable until maturity.

Example: In November 2010, an investor buys a six-month T-bill. The interest is not taxable until 2011 assuming the T-bill is held to maturity.

• Interest on U.S. Series EE savings bonds

Other than not being taxable until the proceeds are received, interest on issued Series EE bonds may be exempt from tax if the proceeds of the bond are used to pay certain educational expenses for yourself or your dependents, and the requirements of “qualified United States savings bonds” are met.

Planning Suggestion: Consider investments that generate interest exempt from the regular income tax. You must, however, compare the tax-exempt yield with the after-tax yield on taxable securities to determine the most advantageous investment. In addition, some tax-exempt interest may be subject to AMT (see page 14), which could lower the tax-exempt yield.

Other ways to defer income include installment sales and tax-free exchanges of “like-kind” investment or business property.

Planning Suggestion: If you made a 2010 sale that is eligible for installment reporting, you have until the due date of your 2010 return, including extensions, to decide if you do not want to use the installment method and, instead, report the entire gain in 2010.

For Employees

• Year-end bonuses and deferred compensation

Caution: The Service will scrutinize deferrals of income between owner-employees and their closely-held corporations. Also, any deferred compensation arrangements must be entered into before the compensation is earned. Additionally, if you own more than 50 percent of a taxable (C) corporation or any stock of an S corporation that reports on an accrual method of accounting, the corporation can deduct a year-end bonus to you only when it is paid.

Planning Suggestion: The tax rate for the Medicare Hospital Insurance portion of the social security tax is:

• 1.45 percent for employees;
• 1.45 percent for employers; and
• 2.9 percent for self-employed individuals.

This tax is imposed on all employee compensation and self-employed income, including vested deferred compensation, without any limitation or cap. If you are a shareholder in an S corporation, you might be able to reduce the Medicare tax by reducing your salary. However, reasonable compensation must be paid to S corporation shareholders for services rendered to the S corporation. Note also that scheduled increases in this tax rate for employees and the self-employed with higher income levels will not take effect until 2013.

• Distributions from retirement plans

Distributions from qualified retirement plans can be delayed.

Caution: Penalties may be imposed on early, late, or insufficient distributions.

• IRA distributions

All distributions from a regular individual retirement account (“IRA”) are subject to ordinary income taxes. This tax liability can be delayed until age 70½ at which time the minimum required distributions must begin (see page 8). However, the ten-percent early withdrawal penalty does not apply if you are over 59½ and would take a voluntary distribution in order to accelerate ordinary taxable income into 2010. Penalty-free access to the funds is available prior to age 59½, to the extent the distribution is used to pay medical expenses in excess of 7½ percent of your adjusted gross income (“AGI”) or to pay any health insurance premiums, provided you have received unemployment compensation for at least 12 weeks.

If you are planning to purchase a new home, you may withdraw up to $10,000 from your IRA to pay certain qualified acquisition expenses without having to pay the ten-percent early withdrawal penalty. The distribution is still subject to the regular income tax. The $10,000 withdrawal is a lifetime cap. If a taxpayer or spouse has owned a principal residence in the previous two years, this penalty-free provision is not available. An eligible homebuyer for this purpose can be the owner of the IRA, his or her spouse, child, grandchild, or any ancestor. Also, penalty-free distributions can be made from IRAs for higher education expenses of a taxpayer, spouse, child, or grandchild.

• Accelerated insurance benefits

Subject to certain requirements, payments received under a life insurance policy of an individual who is terminally or chronically ill are excluded from gross income. If you sell a life insurance policy to a viatical settlement provider (regularly engaged in the business of purchasing or taking assignments of life insurance policies), these payments also are excluded from gross income.

• Educational expense exclusion

An exclusion for employer-provided education benefits for nongraduate and graduate courses up to $5,250 per year is available. The educational expense exclusion continues to be available for the 2011 and 2012 for taxable years, after giving effect to the extension provided by the 2010 Tax Relief Act.

The “above-the-line” deduction for tuition was also extended for two years by the 2010 Tax Relief Act. However, inasmuch as its prior expiration date was December 31, 2009, the deduction is now available for 2010 and 2011. You may be eligible for a tuition deduction of up to $4,000 for higher education expenses if your AGI does not exceed $65,000 (or $130,000 if filing a joint return). If your AGI is greater than $65,000 (or $130,000 on a joint return), but does not exceed $80,000 (or $160,000 if filing a joint return), your maximum tuition and fees deduction will be $2,000. Once your AGI exceeds $80,000 (or $160,000 on a joint return), a deduction will not be allowed. The $4,000 limit must be reduced for those higher education expenses that are not subject to tax, i.e., United States Government interest used to pay higher education expenses; distributions from state tuition programs (section 529 plans); or distributions from educational IRA plans.

• Educators' out-of-pocket classroom expenses

The $250 (maximum) deduction for educator expenses was also extended for two years by the 2010 Tax Relief Act. However, inasmuch as its prior expiration date was December 31, 2009, the deduction is now available for 2010 and 2011. Eligible educators can deduct $250 (subject to various limitations) of their classroom expenses as above-the-line deductions. These are expenses that would otherwise be allowable as trade or business deductions. The balance of the educators’ classroom expenses is deductible as an unreimbursed employee business expense, a miscellaneous itemized deduction subject to the two-percent-of-AGI floor.

• Damages received for non-physical injuries and punitive damages

All amounts received as punitive damages and damages attributable to non-physical injuries are gross income in the year received. Legal fees attributable to non-business income or to employment related unlawful discrimination lawsuits are a reduction of gross income, instead of a miscellaneous itemized deduction. Damages received by a spouse, which are attributable to loss of consortium due to physical injuries of the other spouse, are excluded from income.

Controlling Deductions

For prior taxable years, itemized deductions, other than investment interest, medical expenses, and casualty or theft losses, were reduced by a specified percentage of the amount by which a taxpayer’s AGI exceeded a certain limit. However, these itemized deductions were not reduced by more than 80 percent of the otherwise allowable deductions. For the taxable years 2010 through 2012, the reduction of itemized deductions is eliminated, after giving effect to the two-year extension provided by the 2010 Tax Relief Act.

Deductions that may be accelerated into 2010 or deferred to 2011 include:

• Charitable contributions (cash or property)

You must obtain written substantiation, in addition to a canceled check, for all charitable donations.

Charities are required to inform you of the amount of your net contribution, where you receive goods or services in excess of $75 in exchange for your contribution.

If the value of contributed property exceeds $5,000, you must obtain a qualified written appraisal (prior to the due date of your tax return, including extensions), except for publicly-traded securities and nonpublicly- traded stock of $10,000 or less.

Planning Suggestion: If you are considering contributing marketable securities to a charity and the securities have declined in value, sell the securities first and then donate the sales proceeds. You will obtain both a capital loss and a charitable contribution deduction.

Caution: If you are contemplating the repurchase of the security in the future, you need to consider the wash sale rules discussed on page 6.

On the other hand, if the marketable securities or other long-term capital gain property have appreciated in value, you should contribute the property in kind to the charity. By contributing in kind, you will avoid taxes on the appreciation and receive a charitable contribution deduction for the property’s full fair market value.

If you contribute appreciated, publicly-traded stock (with no restrictions) to a private foundation, you are entitled to a charitable contribution deduction for the full fair market value of the stock. If you wish to make a significant gift of property to a charitable organization yet retain current income for yourself, a charitable remainder trust may fulfill your needs. A charitable remainder trust is a trust that generates a current charitable deduction for a future contribution to a charity. The trust pays you income annually on the principal in the trust for a specified term or for life. When the term of the trust ends, the trust’s assets are distributed to the designated charity. You obtain a current tax deduction when the trust is funded based on the present value of the assets that will pass to the charity when the trust terminates. This accelerates your deduction into the year the trust is funded, while you retain the income from the assets. This method of making a charitable contribution can work very well with appreciated property. If you volunteer time to a charity, you cannot deduct the value of your time, but you can deduct your out-of-pocket expenses. If you use your automobile in connection with performing charitable work, including driving to and from the organization, you can deduct 14 cents per mile. You must keep a record of the miles.

The allowable deduction for donating an automobile (also, a boat and airplane) is significantly reduced. The deduction for a contribution made to a charity, in which the claimed value exceeds $500, will be dependent on the charity’s use of the vehicle. If the charity sells the donated property without having significantly used the vehicle in regularly conducted activities, the taxpayer’s deduction will be limited to the amount of the proceeds from the charity’s sale. In addition, greater substantiation requirements are also imposed on property contributions. For example, a deduction will be disallowed unless the taxpayer receives written acknowledgement from the charity containing detailed information regarding the vehicle donated, as well as specific information regarding a subsequent sale of the property.

• Medical expenses

In addition to medical expenses for doctors, hospitals, prescription medications, and medical insurance premiums, you may be entitled to deduct certain related out-of-pocket expenses such as transportation, lodging (but not meals), and home healthcare expenses. If you use your car for trips to the doctor during 2010, you can deduct 16½ cents per mile. Payments for programs to help you stop smoking and prescription medications to alleviate nicotine withdrawal problems are deductible medical expenses. Uncompensated costs of weight-loss programs and diet food to treat diseases diagnosed by a physician, including obesity, are also deductible medical expenses.

Planning Suggestion: If you pay your medical expenses by credit card, the expense is deductible in the year the expense is charged, not when you pay the credit card company. It is important to remember that prepayments for medical services generally are not deductible until the year when the services are actually rendered. Because medical expenses are deductible only to the extent they exceed 7½ percent of AGI, they should, where possible, be bunched in a year in which they exceed this AGI limit. Note that a recently enacted increase in the threshold from 7½ percent to ten percent for certain taxpayers will not take effect until 2013.

Under certain conditions, if you provide more than ten percent of an individual’s support, such as a dependent parent, you can deduct the unreimbursed medical expenses you pay for that individual to the extent all medical expenses exceed 7½ percent of your AGI. Even if you cannot claim that individual as your dependent because his or her gross income is $3,650 or more, you are still entitled to the medical expense deduction. Please consult your BDO or Alliance firm client service professional for details.

• Long-term care insurance and services

Premiums you pay on a qualified long-term care insurance policy are deductible as a medical expense. The maximum amount of your deduction is determined by your age. The following table sets forth the deductible limits for 2010:

These limitations are per person, not per return. Thus, a married couple over 70 years old has a combined maximum deduction of $8,220, subject to the normal limitation on medical expenses of 7½ percent of AGI.

Generally, if your employer pays these premiums, they are not taxable income to you. However, if this benefit is provided as part of a flexible spending account or cafeteria plan arrangement, the premiums are taxable to you. The deduction for health and long-term care insurance premiums paid by a self-employed individual is covered in the box on page 10 “Tax Tips for the Self-Employed.”

Medical payments for qualified long-term care services prescribed by a licensed healthcare professional for a chronically-ill individual are also deductible as medical expenses.

• Extended coverage for adult children

Beginning in 2010, the Patient Protection and Affordable Care Act of 2010 provides that any plan that covers dependents must be extended to provide coverage of adult children until the day the child reaches age 26. The general exclusion from gross income to include premiums from employer-provided health benefits to any employee’s child who has not attained age 27 as of the end of the tax year is also extended.

• Mortgage interest, and points

Interest as well as points paid on a loan to purchase or improve a principal residence is generally deductible in the year paid. The mortgage loan must be secured by your principal residence. Points paid in connection with refinancing an existing mortgage are not deductible currently but rather must be amortized over the life of the new mortgage. However, if the mortgage is refinanced again, the unamortized points on the old mortgage can be deducted in full. See page 11 for additional information regarding mortgage and other interest payments.

• Interest paid on qualified education loans

An “above-the-line” deduction (a deduction to arrive at AGI) is allowed for interest paid on qualified education loans. All student loan interest up to the $2,500 annual limit is deductible. However, in 2010 this deduction is phased out for single individuals with modified AGI of $60,000 to $75,000 ($120,000 to $150,000 for joint returns).

Caution: Interest paid to a relative or to an entity (such as a corporation or trust) controlled by you or a relative does not qualify for the deduction.

• Non-business bad debts

Non-business bad debts are treated as short-term capital losses when they become totally worthless. To establish worthlessness, you must demonstrate there is no reasonable prospect of recovering the debt. This might include documenting the efforts you made to collect the debt, including correspondence to the debtor to demand payment.

• 401(k) plan contributions

If your employer (including a tax-exempt organization) has a section 401(k) plan, consider making elective contributions up to the maximum amount of $16,500 or $22,000 if over age 50, especially if you are unable to make contributions to an IRA. You should also consider making after-tax, nondeductible contributions to a 401(k) plan if the plan allows, as future earnings on those contributions will grow tax-deferred. A nondeductible contribution to a Roth IRA can also be considered (see page 9).

Planning Suggestion: If you are a participant in an employer’s qualified plan (which includes a 401(k) plan) and are at least 50 years old, you can elect to make a deductible “catch-up” contribution of $5,500 to the plan. To make a “catch-up” contribution, your employer’s plan must be amended to allow such contributions.

• IRA deductions

The total allowable annual deduction for IRAs is $5,000, subject to certain AGI limitations if you are an “active participant” in a qualified retirement plan. A non-working spouse may also make an IRA contribution based upon the earned income of his or her spouse. A catch-up provision for individuals age 50 or older applies to increase the deductible limit for IRAs to $6,000.

Planning Suggestion: Consider making your full IRA contribution early in the year so that income earned on the contribution can accumulate tax-free for the entire year.

Planning Suggestion: If money is tight, consider the use of credit cards to make tax deductible year-end payments. However, interest paid to a credit card company is not deductible because it is personal interest (see page 11).

Caution: If you choose to accelerate income into 2010 or defer deductions to 2011, make sure your estimated tax payments and withheld taxes are sufficient to avoid 2010 estimated tax penalties (see page 16).

Deferred Compensation

Since the creation of section 409A by the American Jobs Creation Act, the deferral or change to a deferral of compensation has become more challenging. Section 409A restricts the timing of distributions from, and contributions to, deferred compensation plans requiring most individuals to:

1. Make an election to defer compensation in the year prior to the year in which the services related to the compensation are performed.
2. Limit the timing of distributions based on one (or more) of six prescribed times or events as follows:

a. separation from service;
b. disability;
c. death;
d. a specified time (or pursuant to a fixed schedule);
e. change in ownership of the company; or
f. an unforeseeable emergency.

Plans that may be affected by these rules include salary deferral plans, incentive bonus plans, severance plans, discounted stock options, stock appreciation rights, phantom stock plans, restricted stock unit plans and salary continuation agreements included in employment contracts.

A violation of these rules requires not only a payment of normal income taxes on all amounts deferred up to time of the violation (or vesting if later), but an additional 20-percent tax as well. This punitive tax makes it challenging to accelerate properly deferred compensation into a current taxable year. However, if you wish to delay income taxes on compensation that you will earn in 2011 to a later taxable year, the agreement to defer generally must be executed before December 31, 2010.

Plans and arrangements that defer compensation should be in full operational compliance in 2010, but the IRS has established a correction program for some 409A failures.

Capital Gains and Losses

For taxable years through 2012, investment strategies that produce long-term capital gain instead of ordinary income can generate significant tax savings because the maximum tax rate on long-term capital gains is 15 percent. Also through 2012, if a taxpayer has a net long-term capital gain, a zero tax rate will apply to adjusted net capital gain that otherwise would be taxed at a rate below 25 percent if taxed as ordinary income.

Caution: The tax law contains rules to prevent converting ordinary income into long-term capital gains. For instance, net long-term capital gains on investment property are excluded in computing the amount of investment interest expense that can be deducted (see page 11), unless the taxpayer elects to subject those gains to ordinary income tax rates. Additionally, if long-term real property is sold at again, the portion of the gain represented by prior depreciation is taxed at a 25-percent rate.

Capital losses are offset against capital gains. Net capital losses of up to $3,000 can be deducted against ordinary income. Unused capital losses may be carried forward indefinitely and offset against capital gains, and up to $3,000 of ordinary income, in future years.

Planning Suggestion: Add up all capital gains and losses you have realized so far this year, plus anticipated year-end capital gain distributions from mutual funds (this amount should be presently available by calling your mutual fund’s customer service number). Then review the unrealized gains and losses in your portfolio. Consider selling additional securities to generate gains or losses to maximize tax benefits.

Caution: Do not sell a security simply to generate a gain or loss to offset other realized gains or losses. The investment merits of selling any security must also be considered.

Note: Capital gains and losses are recognized on the trade date, not the settlement date. For instance, gains and losses on trades executed on December 31, 2010, are taken into account in computing your 2010 taxable income.

If a security is sold at a loss and substantially the same security is acquired within 30 days before or after the sale, the loss is considered a “wash sale” and is not currently deductible. However, this nondeductible loss is added to the cost of the purchased security that caused the “wash sale.” This basis adjustment will reduce gain, or increase loss, later when that security is sold.

Although present tax law significantly limits a taxpayer’s ability to lock in capital gains without realizing the gains for tax purposes, there are still methods by which this can be accomplished. Please consult your BDO or Alliance firm client service professional for further guidance.

Qualified Small Business Stock

A non-corporate taxpayer can exclude specified percentages of any gain realized from the sale of qualified small business stock (“QSBS”). To be eligible, the stock must be issued after August 10, 1993, and must have been held for more than five years. The gain eligible for this exclusion cannot exceed the greater of ten times the taxpayer’s basis in the stock or $10 million. A non-corporate taxpayer may also elect to exclude the entire gain from the sale of “qualified small business stock” held for more than six months if, within the 60-day period beginning on the date of sale, the taxpayer purchases QSBS having a cost at least equal to the amount realized from the sale. The changes in the long-term capital gain rates did not affect the tax treatment of QSBS sales.

As originally enacted, the allowable exclusion percentage was 50 percent. Legislation enacted in 2009 increased the percentage from 50 percent to 75 percent for QSBS acquired after February 17, 2009, and before September 28, 2010. Whether the exclusion percentage was 50 percent or 75 percent, the includible portion of the gain was subject to a maximum tax rate of 28 percent, and a portion of the excluded gain was included in as a tax preference in determining the taxpayer’s liability (if any) for the alternative minimum tax (“AMT”).

Under the Small Business Jobs Act of 2010, qualified small business stock acquired after September 27, 2010, and before January 1, 2011, qualifies for a 100-percent exclusion from gross income of capital gain if the stock is held for more than five years. Moreover, for such stock, the excluded gain is not a preference for purposes of the AMT. As a result, gain from such stock is fully tax-exempt. Because of the five-year holding-period requirement, the earliest a taxpayer can benefit from the 100-percent exclusion would be the calendar year 2015. The 2010 Tax Relief Act extended the full exclusion for one more year, i.e., to QSBS acquired during the calendar year 2011 and held for the requisite five-year period.

Planning Suggestion: Taxpayers desiring to start up a new company or invest in new companies should consider taking advantage of the new 100 percent exclusion and acquire newly issued qualified small business stock prior to year-end. Employees or directors holding stock options in qualified small businesses should consider exercising the options before the end of 2011.

Planning Suggestion: For founders that had originally chosen the limited liability company or partnership form of business for their start-up business, they may wish to consider the corporate form of business. Special care is required in order to “incorporate” a business and still qualify for the full exclusion of gains from sales of QSBS.

Planning Suggestion: Follow-on investments in either cash or property in exchange for stock as an original issuance from the corporation or through an underwriter also qualify for exclusion of a small business stock gain.

Your BDO or Alliance firm client service professional can be consulted for more information.

Dividend Income

Qualified dividend income from domestic corporations and qualified foreign corporations is taxed at the same reduced rate as long-term capital gains for regular tax and AMT purposes. The rate reduction for dividend income, which originally was scheduled to expire at the end of 2010, now applies to qualified dividends received in taxable years through 2012, after giving effect to the 2010 Tax Relief Act. Thereafter, these rate reductions are scheduled to sunset and the older higher rates for dividend income and long-term capital gains are scheduled to return.

Planning Suggestion: For taxpayers who are owners of closely held corporations or a corporation that was converted to an S corporation, there are some planning opportunities available in light of the lower dividend tax rates. Your BDO or Alliance firm client service professional can be consulted for further guidance.

Tax-Free Rollover Into Specialized Small Business Investment Companies

An individual may elect to avoid tax on gains from sales of publicly traded securities to the extent the sales proceeds are used to purchase common stock or a partnership interest in a specialized small business investment company licensed by the Small Business Administration under the 1958 Small Business Investment Act. The rollover of sale proceeds must occur within 60 days of the sale. The maximum gain that may be avoided annually for a single individual or a married couple filing jointly is the lesser of $50,000 or $500,000 reduced by any gain avoided in previous years. The limits are one-half of these amounts for married individuals filing separate returns.

Sale of Principal Residence

For sales of a principal residence, up to $500,000 of gain on a joint return ($250,000 on a single or separate return) can be excluded. To be eligible for the exclusion, the residence must have been owned and occupied as your principal residence for at least two of the five years preceding the sale. The exclusion is available each time a principal residence is sold, but only once every two years. Special rules apply in the case of sales of a principal residence after a divorce and sales due to certain unforeseen circumstances. If a taxpayer satisfies only a portion of the two-year ownership and use requirement, the exclusion amount is reduced on a pro rata basis.

Example: Husband and wife file a joint return. They own and use a principal residence for 15 months and then move because of a job transfer. They can exclude up to $312,500 of gain on the sale of the residence (5/8 of the $500,000 exclusion).

Legislation enacted in 2008 modified the provisions affecting the exclusion of the gain. For sales or exchanges after December 31, 2008, a portion of the gain attributable to a period when the residence is not used as a principal residence will not be eligible for the exclusion. Periods of ineligible use prior to January 1, 2009, will not be considered.

Planning Suggestions: If you want to sell your principal residence but are unable to do so because of unfavorable market conditions, you can rent it for up to three years after the date you move out and still qualify for the exclusion. However, any gain attributable to prior depreciation claimed during the rental period will be taxed at a 25-percent rate.

If you own appreciated rental property that you wish to sell in the future, you should consider moving into the property to convert it to your principal residence. You will need to live in the property for two of the five years preceding the sale of the property. As long as you haven’t sold another principal residence for the two years prior to the sale, a portion of the gain is excluded. Any gain attributable to prior depreciation claimed will be taxed at a 25-percent rate.

The sale of a principal residence does not qualify for the exclusion if during the five-year period prior to the sale the property was acquired in a tax-free like-kind exchange.

Expanded and Extended Homebuyer Credit

The Worker, Homeownership, and Business Assistance Act of 2009, signed into law on November 6, 2009, extends and expands the first-time homebuyer credit allowed by previous Acts. An eligible first-time homebuyer (and a qualifying long-term resident treated as a first-time homebuyer) may claim a first-time homebuyer credit for a home costing $800,000 or less purchased (1) before May 1, 2010; or (2) before October 1, 2010 by a taxpayer who entered into a written binding contract before May 1, 2010, to close on the purchase before July 1, 2010. For qualifying purchases in 2010, taxpayers have the option of claiming the credit on either their 2009 or 2010 return. The maximum credit amount remains at $8,000 for a first-time homebuyer (a buyer who has not owned a primary residence during the three years up to the date of purchase). The law also provides a “long-time resident” credit of up to $6,500 to others who do not qualify as “first-time homebuyers.” In order to qualify as a long-time resident, a buyer must have owned and used the same home as a principal or primary residence for at least five consecutive years of the eight-year period ending on the date of purchase of a new home as a primary residence. The full credit will be available to taxpayers with modified adjusted gross incomes (“MAGI”) up to $125,000, or $225,000 for joint filers. Those taxpayers with MAGI between $125,000 and $145,000, or $225,000 and $245,000 for joint filers, are eligible for a reduced credit. Those taxpayers with higher incomes do not qualify.

Installment Sales of Depreciable Property by Non-Dealers

A sale of depreciable property at a gain generates ordinary income to the extent of any depreciation recapture. This ordinary income is fully taxable in the year of sale even if no sales proceeds are received in that year.

Example: Taxpayer T, in the 35-percent bracket, sells machinery in 2010 for a $1 million note payable in 2011. T's gain is $900,000 ($1 million less $100,000 basis). $800,000 of this gain is due to depreciation recapture. T must report gain as follows:

2010 ordinary gain: $800,000
2011 capital gain: $100,000
Total gain: $900,000

T must pay tax of $280,000 (35 percent of $800,000) for 2010, even though the note proceeds will not be received until 2011.

Planning Suggestion: If possible, an installment seller of depreciable property should structure the transaction to receive enough cash by the due date of the tax return to meet the first year’s tax on the installment sale. In the above example, T should negotiate to receive an installment payment of at least $280,000 by April 15, 2011.

Retirement Plan Distributions

Retirement plans have many requirements regarding distributions, but taxpayers can exercise some authority over plan distributions that might facilitate income tax planning.

For instance, funds in a regular IRA can be accessed without additional early distribution penalties anytime after obtaining age 59½. Therefore, anyone who would benefit from increased ordinary income in 2010 can take a distribution from regular IRAs. Once the IRA owner reaches age 70½, a minimum must be distributed from regular IRAs (Roth IRAs are not subject to any minimum distribution requirements) each year. The law allows, but does not require a small delay until April 1 of the year after the attainment of age 70½. Therefore, if you reached age 70½ in 2010 you should evaluate the benefit of delayed tax liability on your first distribution compared to the spike in your 2011 taxable income that two distributions in 2011 could cause. Any failure to take the minimum required distributions before the annual deadline causes the IRA owner to owe a 50-percent excise tax on the amount that should have been distributed.

Example: Individual reached age 70½ in 2010 and is required to make a minimum required distribution for the 2010 calendar year. This distribution could be made during 2010 based on the December 31, 2009, IRA balance but Individual waited until April 1, 2011, to take the required amount. Individual must also take a distribution by December 31, 2011, for the 2011 year based on the December 31, 2010, IRA account balance, with certain adjustments. Therefore, Individual is taxed on two distributions in 2011 which might result in an overall increase in income taxes.

Another way to utilize IRA funds in a tax-efficient manner is to donate to charity directly from your IRA. Doing so avoids increased adjusted gross income that might have a negative effect on the taxation of social security benefits and allowable deductions. Although this income exclusion for funds transferred directly from an IRA to a charity previously expired on December 31, 2009, the 2010 Tax Relief Act extended the provision through 2011.

The provision allows up to $100,000 of qualifying IRA distributions to
be excluded from taxable income. In order to qualify, the distributions
must be:

• Made after the IRA owner attains age 70½;
• Made directly to a qualifying charitable organization (public charity);
• Entirely deductible as a charitable contribution and not reduced by any benefit received; and
• Sufficiently substantiated.

In addition, a qualifying distribution to charity can be used to satisfy the owner’s minimum required distribution for 2010.

Participants in qualified pension plans, who are not five-percent or more owners of the employer, can delay taking distributions out of the plan beyond the minimum required distribution age of 70½ as long as they are still actively employed by the plan sponsor. If you are already receiving benefits but have not yet retired, your plan may (but is not required to) allow you to stop receiving distributions until you retire.

If you received a taxable qualified retirement plan distribution that is not a part of a series of substantially equal payments over a specified period of ten years or more, over the life expectancy of the employee, over the joint life expectancies of the employee and the employee’s beneficiary, or does not satisfy the minimum required distribution rules, you can generally avoid immediate taxation by “rolling” the money into a regular IRA or other qualified plan. The rollover rules are utilized most often to move retirement funds between IRAs inasmuch as qualified plans are required to allow participants to elect a direct trustee-to-trustee transfer of distributions and to withhold a 20-percent income tax on distributions made directly to participants. Participants who elect to receive a plan distribution net of the required withholding will have to restore the funds from other sources in order to complete a tax-free rollover of 100 percent of the distribution. If 100 percent of the distribution is indeed rolled over within the 60-day timeframe required by law, the distribution is nontaxable but any overpayment of income taxes will be refunded only as a result of filing a Form 1040 for the year.

Example: Employee E retires at age 54 on January 1, 2010, and is entitled to receive a $100,000 lump-sum distribution from his employer’s profit-sharing plan. E does not elect a direct trustee to- trustee transfer of his $100,000 to an IRA. At the time of the distribution, the employer must withhold $20,000 in federal income taxes from the distribution. E receives the remaining $80,000 on January 10, 2010, and transfers it to an IRA on January 11, 2010.

E will have $20,000 of gross income, unless he obtains $20,000 from another source and transfers it to the IRA by March 11, 2010 (within 60 days of receiving the distribution). The $20,000 will be refunded only after taking into account all items reported on E’s Form 1040 for 2010. In addition, if E fails to transfer the additional $20,000 to an IRA, E will be liable for the ten-percent early withdrawal penalty on the $20,000 because E was under age 55 (the minimum age for receiving penalty free distributions upon a separation from service).

Click here to read 2010 Year-End Tax Planning for Individuals - Part 2.