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Newsletter
If you have any questions about the newsletters you see here, just call.
How should you set up your new business?
If you're forming a small business, you face several choices: Sole Proprietorship, Partnership, C-corporation, S-corporation, Limited Liability Partnership and Limited Liability Corporation. This newsletter explores the basic pros and cons you need to know.
Our Top 10 Tax Tips for 2004
Your federal income tax liability can just happen and be an annual surprise, or you can plan your affairs to result in the lowest possible federal tax obligation. We think planning is the best approach. Here are the key individual tax planning steps for 2004 that can save you money at tax time.
Does Marriage Complicate Your Tax Return?
In spite of the 2003 Tax Act and the political hype, the "marriage penalty" that has existed in the tax laws is far from gone. Here is an explanation that will help you understand how marriage may impact your overall tax picture.
What's the "Right Amount" of Compensation for an S Corporation Shareholder/Employee?
The S corporation has been used by small business owners to avoid payroll taxes, and the IRS knows it. Here is a case that describes how a CPA got into trouble with his own S corporation--and how you can avoid the mistakes that were made.
The Home Office Deduction: Know the Do’s and Don’ts
The rules for claiming the home-office deduction keep changing. Here are the latest provisions you need to be aware of.
The Danger in Shareholder Loans Continues in 2004.
Loans between shareholders to closely held corporations are subject to special tax scrutiny and, if not properly documented, will be treated as either distributions to a shareholder or contributions to the capital of the corporation. Either way, the tax results can be adverse.
More Help With Education Costs During 2004
Virtually all taxpayers have new help to pay for education costs in 2004 and beyond. Here's how you may be able to benefit.
To Roth or Not To Roth in 2004? That is the IRA Question!
For many taxpayers, the Roth IRA is one of the best tax-advantaged retirement plans around. Find out if you're eligible to harvest the grapes of Roth, and whether a Roth IRA or a traditional IRA is right for you. We answer the questions that our clients frequently ask.
Sharing Your Stock Market Losses With Uncle Sam
If you've lost money in the stock market, you should be aware of the tax breaks that capital losses can generate. In this concise summary, you will learn how to take full advantage of capital losses and not get caught by the tricky “wash sales” rules.
How should you set up your new business?
If you're forming a small business, you face several choices: Sole Proprietorship, Partnership, C-corporation, S-corporation, Limited Liability Partnership and Limited Liability Corporation. This newsletter explores the basic pros and cons you need to know.
How Should You Set Up Your New Business?
When you start a business, you have many choices to make. One key decision is choosing the form of business entity you will operate under. For starters, you can set up your business as a Sole Proprietorship, C-Corporation, S-Corporation, LLP (Limited Liability Partnership) or an LLC (Limited Liability Company).
How can you narrow that list down? Small businesses typically decide against a C-Corporation, because C-Corps generate two levels of federal income tax. The C-Corporation pays one level of tax when it files its federal corporate tax return, Form 1120. A second layer of tax is imposed when the C-Corporation's profits are distributed to the shareholders as dividends. Those dividends are reported and taxed on the individual's federal tax return, Form 1040. Together, these two levels of taxes are referred to as “double taxation.” In addition, state taxes also typically apply to both C-Corporation profits and distributed dividends. Overall, the tax picture for C-Corps is far from ideal for small businesses. Even the reduced tax rate on dividends in the 2003 Tax Act does not completely do away with the disadvantages of double taxation.
Doing business as a sole-proprietor eliminates the double taxation curse. There are no corporate taxes to pay, and you only pay individual taxes on your net profits, typically reported on Form 1040, Schedule C. However, as a sole proprietor, you lack the legal protection that corporate status gives you. Owners of corporations enjoy limited liability, but sole proprietors do not. Simply stated, if you're a sole-proprietor, your personal assets are at risk if the business is sued—very risky indeed!
That leaves LLCs, LLPs, and S-Corporations. LLPs and LLCs are similar in many ways. One key difference is that LLPs must be owned by more than one individual. Remember, the “P” in LLP stands for partnership---by definition a single individual can't own a partnership. So if you had an LLP with two owners and one died, serious problems that might even cause the business to close could result.
The choice quickly narrows to an LLC or an S-Corporation. Which is more appropriate for your business?
Well, they are both “pass-through” entities that allow you to avoid double taxation, operating a business without paying corporate taxes. Net profits are reported by the owners in their individual tax returns. However, both also offer protection from unlimited liability. Your liability will be limited to your investment in either entity.
When choosing between an S-Corporation and an LLC you need to consider many things. What may be appropriate under one set of circumstances may not be in another. Every business is different, and every owner has different needs and expectations. Let’s review the attributes of each type of entity to help you decide.
The S Corporation
Created in 1958, the S Corporation was, for many years, the standard form of organization for conducting a small business. S Corporation status provides a way for you to avoid the double taxation imposed upon C Corporations and their shareholders. One advantage of the S Corporation is that income is taxed personally to the shareholders. However, your personal risk remains limited to your investment. In other words, double taxation is avoided and you get the protection of limited liability.
Your corporation chooses “S-Status” by filing a special election, Form 2553. Bear in mind that the “S” status of the Corporation only impacts taxes. Shareholders of S Corporations have all of the same legal protections as those in C Corporations. But as once said by a famous Tax Court judge, “a corporation is like a lobster pot. It's easy to get into…difficult to get out of.” In other words, once you have established an S Corporation, it would first have to be liquidated if you wanted to change to an LLC.
The Limited Liability Company (LLC)
LLCs started in 1977 in Wyoming and have quickly become a popular form of business entity across the country. By default, LLCs with more than one owner (member) are taxed as Partnerships, while single-member LLCs are taxed as sole proprietorships. As with S corporations, with an LLC you only pay taxes with your personal return. However, if you decide to do business as an LLC, you are not stuck with it. Through special arrangements, an LLC can be set up to become an S Corporation without having to liquidate. There is little risk of triggering a tax by changing from this form of doing business.
Setting Up Shop
Establishing an S corporation is relatively simple and inexpensive. An attorney, or even you, can form a corporation by completing a series of “boilerplate” documents. These forms require you to complete the following information: who will own the business, the business's activity, address, and other miscellaneous details. Aside from being registered as an “Inc., Co. or Corp.”, a corporation can also be registered as P.C. (Professional Corporation). This designation is for professionals who choose to operate in corporate form and is popular with doctors, lawyers, and accountants.
An LLC requires a bit more work to get started. Articles of Organization, to be filed with the state and an Operating Agreement (like a Partnership Agreement), should be drafted by a lawyer. In addition, business information about the LLC must be placed in a published ad to give notice to the public that the company is being started. An LLC can choose to be registered as a P.L.L.C. (Professional Limited Liability Company) when its owners are licensed by the state to engage in a professional practice -- doctors, lawyers, accountants, and so forth.
Distinguishing Characteristics
An S Corporation might be more restrictive than an LLC. There can't be more than 75 shareholders in an S Corporation. In addition, only individuals, estates & qualifying trusts can qualify as shareholders. An S Corporation may not have any non-resident alien shareholders. There can only be one class of stock ownership. Adding a second category or class of ownership terminates the “S” Election, which could lead to unintended and unexpected tax consequences. The income and expenses from an S Corporation are allocated on a per-share/per-day basis. Your businesses' net income, after paying you a reasonable salary, would not be subject to self-employment taxes on your individual return.
The amount of your investment in the S Corporation---your cost basis--is comprised of:
1) Your contributions of cash & property
2) S corporation profits not distributed to you
2) Loans made directly to the Corporation by you
This “Basis” calculation is important because it is your tax cost. The more you have invested, the more “write-offs you can claim when there are losses.
LLCs offer more flexibility than S Corporations. They can have an unlimited number of owners and any person, business or trust can be a member, or owner. With an LLC you can choose to allocate particular types of income and expenses between the owners. Doing this can get pretty complicated, so be sure to speak with our office about "special allocations." In addition, status of the business's net income as subject to Self-Employment taxes is unclear..
The amount of your basis in an LLC (your tax cost) is comprised of:
1) Your contributions of cash & property
2) Your share of the LLCs debts to others. (In an LLC, loans to the company can increase your tax basis if they are guaranteed by you. In an S corporation, only direct loans to the company by you can increase your tax basis.)
LLCs provide more ways to increase your tax cost basis. This illustrates a significant advantage of LLCs over S Corporations. Because of the way these calculations are done, your cost basis may be higher for an investment in an LLC than if you set up shop as an S Corporation.
Conclusion
Many businesses should probably start as an LLC. Advantages include flexibility of ownership, ability to gain tax basis through liabilities, and pass-through of profits and losses. If a corporate entity is determined to be required later, the change from LLC to corporation should be quick and tax free.Go Back
Our Top 10 Tax Tips for 2004
Recent legislation changed several parts of the tax laws affecting individuals. Every year, it's wise to consider how tax planning will be affected, so here are our Top 10 individual tax planning tips for 2004.
Rate Reductions
Rate reductions that were supposed to be phased in over several years were accelerated in 2003. Real planning opportunities have been created by the speed up of the “temporary” rate cuts.
1. Accelerate income. Deferred compensation is attractive when future top rates will be significantly lower than current rates. That is no longer the case. Regular income tax rates now start at 10 percent, and the top rate in 2004 will be 35 percent. Who knows what the future will bring? Take the money now!
2. Seek investments that pay ordinary dividends or distribute capital gains. The maximum tax rate on both is only 15 percent in 2004.
3. Shift income to children and grandchildren. In 2004, the lowest income tax bracket is 10 percent, 25 percent lower than the highest bracket. Be sure that each child and or grandchild has enough income to take full advantage of the $800 exemption and low rates without becoming subject to the tax on investment income of a child under age 14.
New IRA Contribution Limits
In 2004, IRA contributions of up to $3,000 are permitted for anyone with sufficient earned income, and the limit increases to $3,500 for a person that has attained age 50 before year-end. In 2005, the base limit increases to $4,000 so that the total contribution can be as much as $4,500. The limits continue to increase in years after 2005.
4. Make the maximum allowable contribution. The combination of tax-deferred accumulation and new, more liberal, Required Minimum Distribution rules make the IRA the most attractive retirement saving vehicle in history.
5. Make your IRA contribution as early as possible each year. Tax deferred accumulation of income begins the day you fund the IRA, and early funding will provide greater account value at retirement. You can make your 2004 IRA contribution as early as January 2, 2004.
New 401(k) Deferral Limits
Participants in 401(k), 403(b), and 457 plans can take advantage of expanded limits on contributions. The general limit on contributions to such plans in 2004 is $13,000 with an extra $3,000 allowed for individuals over age 50 by year-end. It gets better - - employees will be allowed to defer up to 100 percent of their compensation up to the deferral limit, if the plan has been amended to permit it.
6. Defer the maximum allowed by your employer's 401(k) plan - that should also assure you of receiving maximum benefit from any employer matching contribution.
7. A non-working spouse might consider working to boost the family retirement assets - reentering the work force for the primary purpose of making a maximum 401(k) deferral, the lesser of $13,000 or total compensation in 2004, and making a significant improvement in the family retirement assets.
Expanded Education Incentives
Coordinated rules for Section 529 plans, Coverdell Accounts, Hope credits and Lifetime Learning credits allow all of those sources of funding higher education expenses to be of greater utility to many families. Planning which education costs to pay from what funding source, and when to pay them, is necessary in order to gain maximum benefit from all available tax advantaged education assistance programs. Two new opportunities, first available in 2002, continue to be good ideas in 2004.
8. Take advantage of the Education Expense Deduction. In addition to all other assistance provisions, and requiring careful coordination with them for maximum benefit, a deduction of up to $3,000 is allowed for college tuition costs. If your adjusted gross income does not exceed $65,000 for singles, or $130,000 for married taxpayers filing joint returns, you qualify. No deduction can be claimed for expenses of a student for whom a Hope or Lifetime Learning credit is also claimed.
9. Fully fund Coverdell Education Savings Accounts - Contributions of up to $2,000 per child are allowed each year, and the benefit is not phased out until contributors have adjusted gross income in a joint return between $190,000 and $220,000. Tax-free withdrawals are also allowed for qualified elementary and secondary education expenses. If you begin funding early enough, and maximum fund all available programs, you can use the Coverdell account for pre-college costs and coordinate a Section 529 Plan with the Hope credit and Lifetime Learning credit for higher education expenses.
10. Fund a Section 529, Qualified Tuition Program (QTP) - tax-free distributions can pay for many higher education expenses. In addition, QTP distributions can be coordinated with Hope and Lifetime Learning credits as long as each is used to cover different expenses.Go Back
Does Marriage Complicate Your Tax Return?
In spite of the 2003 Tax Act and the political hype, the "marriage penalty" that has existed in the tax laws is far from gone. Here is an explanation that will help you understand how marriage may impact your overall tax picture.
The "marriage penalty" still exists. The 2003 Tax Act made the standard deduction, and the 10 and 15 percent rate brackets for married persons filing jointly, exactly double those for single individuals, accelerating the 2008 and 2009 changes that were part of the 2001 Tax Act. However, the penalty built into rate schedules still applies to couples with higher incomes.
Adding complexity, the changes “sunset” at the end of 2004. Then, in 2005, phased annual adjustments that were part of the 2001 Act kick in, and starting at 2001 amounts, increase the standard deduction for couples and phase-in rate adjustments over a multi-year period until married filing jointly rates are once again double that of single taxpayers in 2009. Experts have pointed out several other provisions of the tax law that have extraordinary effect on married persons filing joint returns, but Congress has shown little interest in genuine reform to eliminate them.
The effect on your income tax liability is just one important financial consideration when planning marriage. We can help you prepare the necessary information for a pre-nuptial agreement, arrange reviews of your and your prospective spouse's credit records, project your joint tax liability for estimated tax purposes, and help the two of you prepare a coordinated financial plan. Just call for an appointment.Go Back
What's the "Right Amount" of Compensation for an S Corporation Shareholder/Employee?
The S corporation has been used by small business owners to avoid payroll taxes, and the IRS knows it. Here is a case that describes how a CPA got into trouble with his own S corporation--and how you can avoid the mistakes that were made.
An unpublished 2001 opinion of the U.S. Tax Court provides an important insight into the issue of "reasonable compensation" when considering a defensible minimum amount for an S corporation shareholder/employee. Many tax advisors agree that you can use this opinion as reliable guidance (even though it is not binding precedent) when planning such compensation. Here's a brief summary of the relevant facts and the Court's decision.
Wiley Barron, a CPA, formed an S corporation to practice public accounting in Arkansas. The S corporation made substantial distributions of profits to him, but treated only $2,000 - - in one quarter during a three-year period - - as compensation subject to employment taxes. The S corporation was examined for payroll tax compliance by an IRS "officer/examiner" specially trained to deal with worker classification and payroll tax issues. She assessed payroll tax deficiencies to account for reasonable compensation and Wiley appealed to the U.S. Tax Court, where he represented himself under the Court's small case procedures.
In its opinion (T.C.Summ. 2001-10), the Tax Court said that Wiley "was the individual who was solely responsible for making management decisions and for controlling every facet of (his) business.” He was the only CPA employed by the corporation, he worked at it pretty much full time, but he didn't pay himself a salary. Since the general rule is that a corporate officer is an employee [See Internal Revenue Code Section 3121(d)], it's fairly obvious that Mr. Barron was using his S corporation to avoid employment tax on his compensation: in this case, all or part of the S corporation's earnings which were distributed to him.
Mr. Barron is certainly not the first small business owner to use an S corporation to avoid payroll taxes on his income, and the IRS has aggressively pursued many of them. Until now, the position of the IRS had been - - and the Courts had generally agreed - - that the entire amount of S corporation distributions should be reclassified as compensation.
But the outcome of this particular case is unique and offers guidance for establishing reasonable compensation at less than total distributions from the S corporation. The Tax Court agreed with the revenue officer/examiner's proposed adjustments, which were based on information from Robert Half Associates regarding what "reasonable compensation" for a CPA of Mr. Barron's training and experience would be - - in the area of Arkansas where he practiced. That "reasonable compensation" was in the range of $45,000 to $49,000 for the years in dispute. Even though the S corporation had distributed from $56,000 to $83,000 in those years, only the amount of "reasonable compensation" based on the reliable comparable data was recharacterized as compensation and subjected to Social Security and Medicare taxes.
You do not have to live with uncertainty on this issue. We can help you determine reasonable compensation levels for S corporation shareholder/employees. We have full access to reliable comparable data and a complete library of federal tax reference material. Please call us to schedule an appointment.
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The Home Office Deduction: Know the Do’s and Don’ts
The rules for claiming the home-office deduction keep changing. Here are the latest provisions you need to be aware of.
The tax law allows consultants, salespeople and other self-employed workers to deduct home office expenses. So can you deduct home office expenses, if you do your administrative or management work at home and have no other office, even though you provide services or see customers away from the home office? As usual, the answer is, “it depends.”
The deduction is permitted if you:
1 - use a portion of your dwelling exclusively as your principal place of business on a regular basis;
2 – use a portion of your dwelling exclusively as a place of business to meet with patients, clients, or customers;
3 – use a separate structure – not attached to the dwelling – exclusively in connection with your trade or business; or
4 – engage in the trade or business of selling products and regularly use a portion of your dwelling to store products or samples.
The deduction is claimed by including a Form 8829 in your Individual Income Tax Return.
We can explain the details of these rules. We know what documentation you need and how to prepare the Form 8829 to claim this important tax benefit. Just give us a call.Go Back
The Danger in Shareholder Loans Continues in 2004.
Loans between shareholders to closely held corporations are subject to special tax scrutiny and, if not properly documented, will be treated as either distributions to a shareholder or contributions to the capital of the corporation. Either way, the tax results can be adverse.
Loans from corporations to shareholders are the subject of an IRS Market Segment Specialization Plan Audit Guide. The IRS also continues to vigorously litigate the status of losses from shareholder loans to closely held corporations. Either way, loans from or loans to, these arrangements must meet certain minimum standards. Here's a list of the most important ones.
- Loans must be evidenced by a written unconditional promise to pay.
- Loans must be due on demand or on a stated due date.
- A rate of interest must be stated or determinable by reference to a published rate.
- The borrower must be creditworthy.
- Payments of principal and interest must be commercially reasonable (no payments,
for years, while interest accrues does NOT meet the standard).
- A source of repayment other than future income should be clearly identified and a
collateral interest established.
Protecting the classification of a loan can mean the difference between ordinary loss and capital loss treatment when a shareholder loan to a corporation cannot be repaid. Going the other way, payments to a shareholder that are not well documented as loans can be reclassified by the IRS as distributions - - taxable dividends or distributions in excess of basis taxable as capital gains. Either way, these are bad outcomes for the individual shareholder.
Now is the time to clean up loan documentation and start making regular payments of principal and interest. In some cases, it may be advisable to borrow from a bank and pay off shareholder loans for a period of two or three months. That would be good evidence that the amount was a bona fide loan.
We can assist you with proper loan documentation and can help you protect your transactions from IRS attack. Call for an appointment to discuss the specifics of your shareholder loans.Go Back
More Help With Education Costs During 2004
Virtually all taxpayers have new help to pay for education costs in 2004 and beyond. Here's how you may be able to benefit.
Students, and their parents, can capitalize on a number of different education benefits. For example, the maximum amount that can be contributed to a Coverdell Education Savings Account (formerly an Education IRA) each year is $2,000. Any family member with adjusted gross income below $190,000 in a joint return or $95,000 in a single return can contribute the maximum to a Coverdell account, where the contribution will grow, tax-deferred, until withdrawn for any of a liberal list of education costs - - even private elementary and secondary tuition. At higher income levels, the maximum contribution is reduced.
State sponsored prepaid tuition plans (Section 529 plans) offer an attractive way to accumulate money to pay higher education costs. Both public and private institutions sponsor tuition savings plans. Parents and Grandparents typically contribute up to $11,000 per year to such plans where income accumulates tax-free. Funds withdrawn from Section 529 plans are totally free from federal income tax if they are used to pay qualified higher education expenses.
Hope and Lifetime Learning credits are also available and several funding sources can be coordinated in order to pay as many costs as possible with tax favored dollars. An education expense deduction, for up to $3,000 of education expenses that are not paid from a Section 529 plan or a Coverdell Account and don't qualify for the Hope or Lifetime credit, is available for taxpayers with modest incomes. That deduction is available whether the taxpayer itemizes deductions or not, but begins to phase out at adjusted gross income levels in excess of $42,000 ($85,000 on a joint return).
Planning education funding for yourself, your children, or your grandchildren may involve coordinating five tax law provisions . . . six, if you count the tax free redemption of Series E bonds to pay higher education costs . . . and you might want some help. We have studied these provisions and are prepared to assist you. Just give us a call to arrange an appointment.Go Back
To Roth or Not To Roth in 2004? That is the IRA Question!
For many taxpayers, the Roth IRA is one of the best tax-advantaged retirement plans around. Find out if you're eligible to harvest the grapes of Roth, and whether a Roth IRA or a traditional IRA is right for you.
Choosing between the Roth IRA and a traditional IRA can be difficult, and it's a big decision. The Roth IRA is a relatively new retirement vehicle, first available in 1998. Not all taxpayers can get full benefit from a Roth IRA, because of rules called "income phaseout limitations." For single taxpayers, the Roth benefit is limited if adjusted gross income exceeds $95,000. . . for joint filers, limitation begins at $150,000.
Married persons filing separately begin losing the benefit with the first dollar of income. In each case, a phaseout range allows a reduced benefit until income reaches a maximum amount. By contrast, regular IRA contributions are not subject to gross income limitations unless the taxpayer or the taxpayer’s spouse is a participant in an employer sponsored plan.
If you're single and your adjusted gross income exceeds $110,000, you cannot contribute to a Roth IRA. You could, of course, contribute to a traditional IRA. On the other hand, if you're a single filer and your income falls below the $95,000 adjusted gross income limit, you can make the full maximum annual $3000 contribution to a Roth IRA. A special "catch-up" contribution can be added to that limit if you've passed your 50th birthday. If your income falls somewhere between this $95,000 - $110,000 range, as a single taxpayer you are eligible to make a partial Roth IRA contribution. The same logic applies to joint filers, subject to the $150,000 - $160,000 phaseout limitations.
Contributions to a Roth IRA are never deductible. However, all the money in a Roth IRA account may be withdrawn completely tax-free if you comply with "qualifying distribution" rules. By contrast, contributions to a traditional IRA may or may not be deductible and therefore may or may not be withdrawn tax free in accordance with the "qualifying distribution" rules.
Whether or not you can deduct contributions to a traditional IRA may depend on your income level when you are covered by an employer’s retirement plan. For tax year 2004, single taxpayers who are covered by an employer's retirement plan can make deductible IRA contributions subject to an adjusted gross income phaseout range of $45,000 and $55,000. For married taxpayers filing jointly, an adjusted gross income phaseout range of $65,000 and $75,000 applies in 2004 if an IRA participant is covered by an employer plan. The phaseout range for an IRA participant who is not covered by a plan but whose spouse is covered is $150,000 - $160,000 of income in a joint return.
What do these rules mean? If you're single, under age 50, covered by an employer plan, and your adjusted gross income exceeds $55,000 in 2004, you cannot deduct any portion of your maximum $3,000 traditional IRA contribution. You can still contribute the $3,000 annual maximum to an IRA, but your entire contribution will be nondeductible. The same logic applies to joint filers, subject to the limitations described above.
So is the Roth better than the traditional IRA? That depends. For taxpayers that are only allowed to make nondeductible IRA contributions, the Roth IRA is clearly preferable. That's because contributions to a Roth IRA may be withdrawn tax-free as "qualifying distributions." Qualifying distributions will also not be subject the 10% early withdrawal penalty tax.
To satisfy the qualifying distribution rules you must not draw from the Roth IRA for the first five years and meet one of six other requirements:
1) The distribution is made after you reach age 59 ½.
2) The distribution is paid because of your death or disability.
3) The distribution consists of substantial equal periodic payments.
4) The distribution is used for qualifying medical or health insurance expenses.
5) The distribution is used for higher education expenses.
6) The distribution is used for a first home purchase and is limited to $10,000
Taxpayers with existing traditional IRA accounts can choose to rollover their IRAs into Roth IRAs. That means paying taxes now so you don't have to pay them later. Whether you should do this depends on many factors that are unique to your own situation. It also requires highly complex "what if" computations that can only be handled by a computer and a skilled tax professional. In fact, different software programs sometimes give different answers, so you really have to be both a tax and computer expert to do this important analysis correctly! We are both happy and prepared to help you. Please don't hesitate to call if you have any questions.Go Back
Sharing Your Stock Market Losses With Uncle Sam
If you've lost money in the stock market, you should be aware of the tax breaks that capital losses can generate. In this concise summary, you will learn how to take full advantage of capital losses and not get caught by the tricky “wash sales” rules.
Uncle Sam is always happy to tax you when you make money. But what happens to your tax situation when you experience losses? The crippling 3-year stock market slide that began in March 2000--call it a correction, bear market, or anything else you fancy--produced significant capital losses for many taxpayers, so learning how to take advantage of the tax treatment of capital losses may be as important to you as the recent run-up in the major stock indexes.
Generally speaking, capital gains and capital losses are reported on federal Form 1040, Schedule D, for the year in which the actual sale of capital assets such as stocks, bonds, and mutual funds occurs. A temporary decline (or increase) in the value of an asset is not reported on your tax return; the asset must actually be disposed of. In the eyes of the federal government, the old Wall Street adage applies: "You don't make a profit or take a loss until you sell."
Net capital gains and losses are aggregated, and up to $3,000 of a net capital loss may be deducted against ordinary income items such as wages. Capital losses in excess of $3,000 are carried forward and deducted in future years, subject to the same limitation.
Gains and losses from the sale or disposition of capital assets are classified as long term or short term, depending on how long you held the asset. For example, a long-term capital asset is currently defined as an asset you have held for more than one year. Long-term capital gains generally receive favorable tax treatment. While the top tax bracket for ordinary income items such as wages is 35%, the maximum tax rate for long-term capital gains is capped at 15%. Short-term capital gains are taxed at ordinary income tax rates.
In addition to netting rules that apply when there are both capital losses and gains, you also need to understand the "wash sale" loss provisions, especially if you engage in frequent or "day" trading. The wash sale rule is intended to prevent you from selling assets to claim a tax loss and quickly reacquiring them. The rule stipulates that your loss will be disallowed if you purchase substantially identical stock or securities, including put and call options, within 30 days of the original sale.
The IRS, of course, is on the watch for wash sale violations. The wash-sale period runs for a total of 61 days - - 30 days before and 30 days after the date of the claimed loss. Year-end sales made in December also do not escape this treatment. Even if the tax year ends during the 61-day wash sale period, the loss will be disallowed if the wash sale period is violated.
Here's a coordinated investment and tax strategy you may want to consider.
While the wash sale rule prohibits you from reacquiring substantially identical securities during the specified time period, they do not prohibit you from reacquiring comparable securities. For example, you could sell shares of a pharmaceutical stock like Merck, claim the loss for tax purposes subject to the rules discussed above, and immediately acquire shares of a comparable security such as Pfizer. This is known as tax loss swapping. The theory behind it is that if Merck (the security sold at a loss) subsequently rises, so will Pfizer (the comparable replacement security), giving you both an economic gain and the benefit of the tax loss.
In theory, tax loss swapping is an excellent strategy, but it can prove risky in the real world. For example, the replacement security could go down, even if the disposed-of security recovers. On the other hand, the replacement security could rise a small amount, while the disposed-of security enjoys bigger gains. The acceptable risk and return ratio and performance spread for tax loss swapping depends on many factors, including your tax bracket, liquidity, net worth, and risk tolerance.
The fundamental economics of investment decisions should not be overlooked because of the tax consequences. The laws and risks applicable to wash sales and tax loss swapping are complex and mistakes can be expensive. We are highly experienced with both issues. Please feel free to call if you have questions about using your capital losses.
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