Plan to Escape 2001/2002 Tax Bug Bite
By: Richard L. Goldstein, MBA, CPA

By the time you read this, December 31 will be gone. Planning to reduce the amount you owe Uncle Sam is basically over. Now would be a good time to make sure that the year 2002-tax bug does not bite you too hard. This month’s column discusses some planning considerations for 2002 and some last minute ideas when preparing your 2001 tax return.

Your tax liability should not be a surprise on April 15, 2002. If you don’t know what your 2001 tax situation is by the time you read this column, your tax bill will be higher than it could have be. It still makes sense to talk things over with your CPA. He or she just may be able to give you some tax savings ideas and start the planning process for 2002.

Alternative Minimum Tax

If your 2001 tax liability is based on the Alternative Minimum Tax (AMT), there is a good possibility that you permanently lost tax deductions. The AMT affects taxpayers with large amounts of preference items. For example, I have seen taxpayers take tax planning into their own hands by accelerating deductions. This strategy includes the prepayment of state taxes and business expenses, only to find that no tax benefit was achieved. Moreover, these deductions become lost because they cannot be deducted in 2002.

You may have deductions for medical expenses, taxes, home mortgage interest not used to buy build or improve your home, miscellaneous itemized deductions, investment interest, or exercised incentive stock options and/or received tax exempt interest from private activity bonds. While these items may be deductible or not taxable for regular income tax purposes, the same may not be true under the AMT system.

How do you cope with the AMT? One strategy, for a taxpayer who is consistently subject to AMT year after year, is spread out the preferences over two or three years rather than compressing them into one. This takes advantage of the AMT exemption amounts. An example may to pay your 2002 state tax liability in 2003 rather than 2002 if a tax benefit will not result.

Deemed Sale and Repurchase Election

The media has been writing and talking about this election. Nevertheless, you may not understand what is involved. Under this election, you may elect to treat any readily tradeable stock (which is a capital asset and includes shares issued by an open-end mutual fund) held by you on January 1, 2001, as having been sold on January 2, 2001 for its closing market price on that date, and as having been reacquired on that date for its closing price. You may elect to treat any other capital asset or property used in your business and held on January 1, 2001 as having been sold on that date for its fair market value on that date, and reacquired on that date for its fair market value. Once the election is made it is irrevocable.

This election is made by reporting the deemed sale(s) on your timely filed return (including extensions). If the deemed sale results in a loss, enter zero on the tax return because the election can’t result in a taxable loss.

Why the election? For tax years beginning after 2000, gain from the sale or exchange of property held more than five years that would otherwise be taxed at 10% capital gain rate is instead taxed at 8%. Gains from the sale or exchange of property held more than five years with a holding period that begins after December 31, 2000, that would otherwise be taxed at a 20% rate will be taxed at an 18% rate.

You may want to make this election for an asset which as of January 1, 2001 hasn’t appreciated substantially (so that no gain or only a small gain is recognized) but which you expect top hold for at least five more years and which you expect further appreciation. This would also be a good move if you have losses in 2001 to offset the gain recognized in making the election. The election should not be made if it will cause a substantial tax to be recognized immediately, since the result of the election will be to save only 10% of the tax (i.e., the maximum tax rate is reduced from 20% to 18%) that would otherwise have to be paid.

The election can also backfire if you are in a high tax bracket when the election is made but the gain on the later stock sale would be taxed at the 15% rate if it were ordinary income instead of capital gain. Where this to happen, you would have paid a 20% tax on the deemed gain that would otherwise have been taxed at 8%.

Keogh Plan

If you are self-employed, you should have established a Keogh plan to jump-start your retirement savings and get a tax break. If this was not done by December 31, deductible contributions for 2001 cannot be made. If a plan was established by December 31 and you are short on cash, the contribution can be made as late as the extended due date of your 2001 tax return (including extensions) without losing the tax deduction. If you missed the year-end deadline to establish a Keogh plan, consider establishing a Simplified Employee Pension Plan for 2001 in 2002. (There is no year-end deadline for a SEP.) Keogh plans, however, can be designed to provide more flexibility for a self-employed business owner than a SEP can provide. The Keogh also has less comprehensive coverage requirements for other employees.

It is always better to establish and fund a plan immediately (you start building tax deferred earnings earlier).

Taking S Corporation Losses

September 11th and the economy in general may have converted what was budgeted to be a profitable year into a loss year. A shareholder of an S corporation can deduct his/her pro-rata share of losses only to the extent of his or her total basis in (a) the S corporation stock, and (b) debt owed him or her by the S corporation. This determination is made as of the end of the tax year in which the loss occurs. Any loss or deduction that can’t be used on account of this limitation can be carried forward indefinitely and deducted as long as you have basis to deduct the loss. If your 2001 tax loss will be limited, you need to start planning for 2002 now. Consider lending the S corporation more money or making a capital contribution by the end of the S corporation’s tax year (in most cases December 31, 2002).

Hire Your Kids

Employing your children after school or during vacation time is often an overlooked benefit. It permits a business deduction for the compensation paid and shifts income to lower income family members. Since the compensation is "earned income," have your children establish an IRA. Making a traditional IRA contribution coupled with the standard deduction means that $7,700 can be paid in 2002 with no income tax cost to the child/employee. Alternatively, the child can establish a Roth IRA. Even though the contributions are not tax deductible, the child has a great head start on building a tax-free source of retirement funds. Additionally, you or your child need pay no social security taxes if you are a sole proprietorship (or a single member LLC) or a partnership owned by you and your spouse and the child is 17 or younger. No FUTA tax is due in this situation, if the child is under 21.

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