Pennsylvania Trusts and Estates Blog

It is likely that taxes at all levels will increase to pay for the massive spending that has taken place. Taxing governments should be wary of raising taxes too far, too fast. According to 2007 IRS statistics the top 1% of U.S. Taxpayers paid 40.4% of federal individual income taxes. At some point, further increases of tax burden on the same individuals will affect behavior. As taxpayers react to tax increases, they may leave a state or even a country for more tax friendly environments.

The Wall Street Journal ran an editorial in May 2009 describing the situation in Maryland. In 2008 Maryland enacted a "millionaire's tax." The legislature increased the marginal income tax rate to 6.25% on incomes of more than $1 million. Since cities like Baltimore and Bethesda also impose income taxes, the state and local combined rates could be as high as 9.45%. The millionaire's tax was estimated to bring in an additional $328 million in revenue over three years to the state coffers. In 2008 roughly 3,000 income tax returns with a million or more dollars of reported income were filed by Maryland residents. In 2009, there were only 2,000. The revenue from this groups of taxpayers was down $100 million (not up as predicted). The net result is that state of Maryland actually collected less tax from the millionaires by raising the tax rate, instead of the increase they projected. The WSJ surmises that Maryland's millionaire population fell by a third. They changed which state they claim as their legal residence. That's why the legislation is referred to as the "Get Out of Maryland Tax Act."

Rochester New York billionaire Tom Golisano made a highly publicized move to Naples, Florida because of high taxes in New York State. Golisano said the new New York State budget would result in his paying $5 million in income tax to New York State. In Florida he will pay zero income tax. Read his piece on "Why I'm Leaving New York."

Toronto attorneys Lesperance & Associates, who advise wealthy U.S. citizens on the "how to" of expatriation, have created a video called "Flight of the Golden Geese." It is about Goldie, a goose who lays golden eggs. (You can see it here.) In the video, Goldie alone was covering over 40% of the cost of the farm. The farmer said he needed more eggs. Goldie responded that the other animals should contribute, as well. The other animals called Goldie names - greedy, disloyal, selfish and disloyal to the farm. The Farmer said "Let's vote on it. Everybody in favor of Goldie giving more eggs raise your hoof, paw, or wing." What happened to the goose who laid the golden eggs? She left the farm, flying to another country where she didn't have to give up so many of her golden eggs to the farmer. As did Goldie, some individuals will choose to move to lower-tax countries.

Concerned about crushing estate, capital gains, and income taxes as well as personal security risks and the threat of litigation in the U.S.; wealthy U.S. citizens are looking at other countries. Other U.S. citizens who we would not classify as "wealthy" are looking to move to lower-tax jurisdictions as well. It is happening at such a rate that Congress enacted the Heroes Earnings Assistance and Relief Tax Act of 2008 (the "HEART Act") which contains provisions to deter high net worth U.S. citizens or long term residents from avoiding payment of U.S. taxes by imposing an immediate exit tax on both the U.S. and foreign assets of individuals who relinquish their citizenship or who give up their green cards. How wealthy? The exit tax applies if you meet on of these three criteria: (1) for the period of five taxable years ending before the year of expatriation the individual has an average annual income tax liability of at least $145,000, (2) a net worth at the date of expatriation of at least $2 million, or (3) the individual would have failed to satisfy all applicable U.S. tax obligations for the five tax years before the year of expatriation.

Before you decide to take flight, there are things to consider. What about your health insurance? Medicare only pays in the U.S. - will your supplemental coverage cover you in the country where you are relocating? Will you be able to get the immigration status you need in the new country Will your retirement income support the lifestyle you want in the new country? What are the estate tax considerations?

Likewise, taxing authorities should consider the ability of geese who lay golden eggs to assume ever-increasing tax burdens.

Congratulations to Doug Smith on the opening of the Central Pennsylvania Federal Tax Clinic (CPFTC). The clinic is located at 601 South Queen Street, Lancaster, PA 17608-0599. Get more information at www.pataxhelp.org or call Doug Smith at (717) 299-7388 X3911.

Enelly Betancourt, staff writer for the Lancaster Newspapers reports:

Low-income taxpayers can receive free legal assistance or advice at a new taxpayer clinic.

The new Community Action Program clinic helps taxpayers who have tax controversies with the Internal Revenue Service.

It also informs individuals who have a limited English proficiency about their rights and responsibilities under federal tax law.

The clinic, at CAP's 601 S. Queen St. headquarters, is open Monday through Friday from 9 a.m. to 5 p.m.

Appointments are required.

"We currently provide income-tax preparation services, but there is a tremendous need in the area of tax controversy assistance," Mark Esterbrook, CAP's chief executive officer, said.

The clinic's primary goal is to prevent additional hardship among the working poor by ensuring that low-income taxpayers always have a source of free legal assistance.

"We understand that this is the first clinic of its kind between Philadelphia and Pittsburgh," Brian Sweigart, CAP communications officer, said.

Named manager of the new CAP clinic is Douglas Smith. He is one of two lawyers nationwide named public service fellows by the American Bar Association's Section of Taxation. His two-year ABA fellowship covers his salary and benefits.

Smith previously was in private practice as a tax and estate planning attorney.

Also helping to fund the clinic will be an IRS Low Income Taxpayer Clinic grant, in an amount that's yet to be determined, Sweigart said.

For information or to request an appointment, call 299-7388, ext. 3911.

Many loans among family members are interest free. Be careful. If you loan money to a relative or friend, there may be income and/or gift tax consequences if there is no interest or if the interest is below the market rate.

For loans of $10,000 or less, you don't have to worry about any of this. Such a loan may carry little or no interest, and there are no income tax consequences or reporting requirements.

For loans of $10,001 to $100,000 (all loans between the borrower and lender are added together for this threshold), the forgone interest to be included in income by the lender and deducted by the borrower is limited to the amount of the borrower's net investment income for the year. If the borrower's net investment income is less than $1,000, it is deemed to be zero.

What does the borrower's net investment income have to do with it? One of the purposes of these rules is to prevent taxpayers from shifting income to kids or other family members who are in lower tax brackets. For example, Dad loans his 19 year old Son $100,000. Son invests it, receives interest, dividends, and capital gain income which Son reports on his own 1040 and pays no income tax. Then Son repays the $100,000 to Dad. The effect of this has been (1) Dad has made a gift to Son of the income and (2) the income has been taxed at lower brackets, in fact, at zero.

If, on the other hand, Dad lends Son $100,000 to buy a house, or to pay for college, and Son uses the loan proceeds for the intended purpose, then there has been no income-shifting. No income is being generated by the loaned funds. Interest will be imputed to this type of gift loan only to the extent that the son has investment income.

The IRS publishes applicable federal rates (AFRs) monthly. There are interest rates for short, mid, and long-term loans. Short-term rates are for demand loans and term loans of 3 years or less; mid-term is for 3-9 years; and long-term is over 9 years. For example, the short-term AFRs for January 2010 are short-term 0.57%, mid-term 2.45%, and long-term 4.11%.

For demand loans, the difference between the interest calculated using the stated rate and the applicable federal rate is generally treated as income to the lender and a gift from the lender to the borrower on December 31 of each year that the loan is outstanding. A demand loan is payable in full at any time on the lender's demand.

For term loans, a lender who makes a below market rate (BMR) loan is treated as having made a gift of the difference between the amount of the loan and the present value of all the scheduled payments, using the applicable federal rate on the date the loan is made. When making a term loan it is usually best to state an interest rate. The Lender may forgive interest payments as they come due. The forgiveness of the interest is a gift and the lender must, nevertheless, include the amount of the interest in income.

The Lender can forgive $13,000 of interest and principal payments using the annual gift tax exclusion. If the loan is from a married couple to a married couple, maybe Mom and Dad to Son and Daughter-in-law, up to $52,000 (4 x $13,000) in interest and principal payments could be forgiven each year with no gift tax consequences. Mom and Dad have interest income to report on their 1040. Son and Daughter-in-law are treated as having paid interest. If the loan was used by Son and Daughter-in-law to buy a home, and if the loan is secured by a mortgage on the home, the interest will be deductible for them as interest on their primary residence mortgage.

For any of these arrangements, make sure the terms are in writing. This accomplishes two things: (1) the terms of the arrangements are clear to the lender, the borrower, and other family members and (2) the loan documentation can stop the IRS from claiming that the transfer of cash was a gift. This is very important. Without written documentation that the transfer is a loan, the IRS can argue that there was no loan at all; it was just a gift. Plus, if the borrower can't make good on the loan, you would need to have this documentation in order to deduct it as a non-business bad debt.

Undocumented loans can become particularly contentious when the lender dies. Documentation establishes whether the loan is to be repaid to the estate or was a lifetime gift. Many times, a family lender, especially to children or grandchildren, does not expect a loan to be repaid after the lender's death. If this is so, it is necessary for the lender to state in his or her will that the balance of principal and accrued interest on the loan is forgiven. Otherwise, the loan will have to be repaid, or will be a set-off against the borrower's distributive share of the estate. Simple documentation can avoid this set-up for a sibling fight and the expense and time that usually ensues.

Starting January 1, 2010 there are many tax changes to deal with. Many tax breaks are phased out. The changes below are the current state of the law. It is always possibly for Congress to act to extend or replace disappearing provisions. The House passed a bill that extended many of these provisions, but the Senate was unable to schedule a vote on it. The Senate has been tied in knots over the health care bill.

Roth IRA Conversions

Starting in 2010 the income cap for converting a traditonal IRA to a Roth IRA is eliminated. Now anyone can do a Roth conversion. If the conversion is done in 2010, taxpayers can spread the income tax attributable to it over two years: 2011 and 2012. Note that while the income cap is removed for purposes of qualifying for the conversion of a traditional IRA to a Roth IRA, there remains an income cap on regular contributions to a Roth IRA. The income phase-out begins at $167,000 for joint filers.

New Vehicle Sales Tax

Individuals will no longer be able to take an itemized deduction or increase the standard deduction for the sales tax on the purchase of a new motor vehicle. Vehicles had to be purchased after February 16, 2009 and before January 1, 2010 to qualify for the deduction.

No More Sales Tax Deduction

The choice to deduct state sales tax payments instead of deducting state and local income taxes is gone. This provision was very important for taxpayers in states like Florida where there is no income tax.

No Phase-outs for Personal Exemptions and Itemized Deductions

In 2010 there will be no phase out of deductions and exemptions for higher income taxpayers. This will greatly benefit high earners.

Teachers' Deduction

The $250 deduction for teachers who buy classroom supplies with their own money is eliminated.

Tuition and Fees

The $4,000 deduction for college tuition and fees expires after 2009. This deduction was permitted "above the line", meaning it could be taken even if the taxpayers didn't itemize.

Contribution to Charity from IRAs

IRA owners older than 70½ who make contributions from their IRAs directly to charity will no longer be able to exclude these withdrawals from income.

No More Property Tax Deduction

Non-itemizers will no longer be able to deduct up to $1000 in property taxes paid. This provision had been a help to home-owners who had no mortgage so that there was no interest deduction to help make itemization worthwhile.

Alternative Minimum Tax Exemptions Reduced

The Alterative Minimum Tax exemption levels fall back to $45,000 for married filing jointly and $33,750 for singles an heads of household. (In 2009 the exemption was $70,950 for married filing jointly and 46,700 for singles and heads of household.) Some commentators say that as many as 1 in 5 taxpayers will be subject to the AMT in 2010.

No Exclusion for Unemployment

The first $2400 of unemployment benefits will no longer be tax-free.

Energy Credit Reduced

The 30% tax credit for the cost of energy-saving home improvements is reduced to 19% and is capped at $500.

Section 179 Expensing

The maximum amount of equipment that can be expensed (instead of depreciated) is reduced to $135,000 to $250,000. Businesses can no longer claim 50% bonus depreciation on assets placed in service in 2010.

Income Tax on Dividends

For taxpayers in brackets higher than 15%, qualified dividends are taxed at a maximum rate of 15% through December 31, 2010. For taxpayers in the 10% and 15% brackets, qualified dividends are taxed at 0% through December 31, 2010. The provisions sunsets on December 31, 2010, and dividend taxation reverts to former 2002 rates.

Mileage Reimbursement

The mileage rates effective January 1, 2010 are 50 cents for business, 16½ cents for medical and 14 cents for charitable purposes.

Home Buyers Credit

If you used the Home Buyers Credit in 2008, you must start paying it back in 2010. The qualification period for first-time home buyers to purchase a home and qualify for the credit continues through May 1, 2010.

Contributions to Retirement Accounts

Remember you have until April 15, 2010 to contribute to a traditional or a Roth IRA. If you have Keogh or SEP and you get a filing extension for your 2009 return until October 5, 2010, you have until that date to make contributions.

No Estate Tax

The federal estate tax is repealed for individuals who die in 2010.

Wild Cards

If the Senate and House eventually hammer out a health care bill that becomes law, there are various provisions in the current legislation on how to pay for it. The House bill includes a 5.4% surtax on high earners and would curtail flexible spending accounts. The Senate bill includes a 40% surtax on high-end employer-sponsored health plans - that provide health coverage valued at more than $8,500 for individuals and $23,000 for families (they call them "Cadillac plans") and increases the Medicare payroll tax. Hold onto your wallet.

The American Recovery and Reinvestment Act of 2009, enacted in February 2009, included among its provisions a new education credit, The American Opportunity Tax Credit.

As it was originally proposed by President Obama, the Act would have provided a $4,000 credit in exchange for 100 hours of community service. That didn't make it to the final version, although the Act does direct the education secretary and the treasury secretary to conduct a feasibility study on requiring community service in order to get the tax credit.

The American Opportunity Tax Credit that was enacted is available in 2009 and 2010 and is an expansion and re-naming of the existing Hope credit. It makes the former Hope credit available to a broader range of taxpayers, including many with higher incomes and those who owe no tax, and allows the credit to be claimed for four post-secondary education years instead of two. However, the American Opportunity Tax Credit is for amounts paid in 2009 and 2010 only. You may be eligible for the lifetime learning credit for any tuition and fees required for enrollment you pay after 2010.

The maximum annual American Opportunity Tax Credit is $2,500 per student. That is a $700 increase from the previous Hope credit.

You can claim the American Opportunity Tax Credit if you pay qualified tuition and related expenses for an eligible student who is either yourself, your spouse, or a dependent for whom you claim an exemption on your federal tax return. You cannot claim the American Opportunity Tax Credit if your tax filing status is married filing separately. Students must attend school at least half-time.

Eligible educational institutions are any college, university, vocational school or other post secondary educational institution eligible to participate in student aid programs administered by the United States Department of Education.

Up to $2,500 of the cost of qualified tuition and related expenses paid during the taxable year qualify for the credit. The credit is student-based, meaning that the credit may be claimed for each eligible student (for example, if a family has two students in college) rather than just one per tax return.

The term "qualified tuition and related expenses" has been expanded to include expenditures for "course materials." For the purpose of this credit, "course materials" means books, supplies and equipment needed for a course of study, whether or not the materials are purchased from the educational institution as a condition of enrollment or attendance. The cost of a computer would qualify for the credit if the computer is needed for enrollment or attendance at the educational institution. Expenses such as insurance, medical expenses, room and board, transportation, or similar personal, living, or family expenses are not included.

The amount of the credit is calculated as 100 percent of the first $2,000 of tuition, fees and course materials, plus 25 percent of the next $2,000 of tuition, fees and course materials paid during the taxable year. If the amount of the American opportunity tax credit for which you're eligible is more than your tax liability, the amount of the credit that is more than your tax liability is refundable to you, up to a maximum refund of 40 percent of the amount of the credit for which you are eligible.

You can't claim the American Opportunity or Lifetime Learning credits for any expenses that were paid from the tax-free portion of a distribution from a 529 plan or a Coverdell Education Savings Account. The credit also can't be claimed for payments made from tax-free scholarships and fellowships, Pell grants, employer-provided tuition reimbursement, Veteran's educational assistance, or other tax-free educational assistance.

Though the income limits are higher than under the existing Hope and Lifetime Learning Credits, this credit also phases out. The full credit is available to individuals whose modified adjusted gross income is $80,000 or less, or $160,000 or less for married couples filing a joint return. The credit is phased out for taxpayers with incomes above these levels. A taxpayer whose modified adjusted gross income is greater than $90,000 ($180,000 for joint filers) cannot benefit from this credit.

A tax deduction of up to $4,000 can be claimed for qualified tuition and fees paid. However, you must choose whether to take a tax deduction or receive a tax credit. You may not claim the tuition and fees tax deduction in the same year that you claim the American opportunity tax credit or the lifetime learning credit. You also cannot claim the tuition and fees tax deduction if anyone else claims the American opportunity tax credit or the lifetime learning credit for you in the same year. Though the credit will usually result in greater tax savings, taxpayers should calculate the effect of both on the tax return to see which is most beneficial -- the tax credit or the deduction.

The credit is claimed using Form 8863, attached to Form 1040 or 1040A. For more information, see IRS Publication 970, Tax Benefits for Education at www.irs.gov.

BUT Beware of Bed Buffaloes!
Read the Wandering Tax Pro's OI VEY! AN UPDATE ON MY LAST POST

Is your retirement plan invested in your employer's company stock? If so, there is a tax strategy available to you that is often overlooked.

Normally, all withdrawals from a retirement plan are taxed as ordinary income, at ordinary income tax rates. However, if you take distribution of your employer's company stock from your retirement plan and hold it in a taxable investment account, you may be able to significantly reduce taxes on plan distributions. This strategy is called the Net Unrealized Appreciation ("NUA") approach. It is authorized by Section 402(e)4 of the Internal Revenue Code.

NUA is the difference between the cost basis of the stock inside the plan and the stock's current market price on the distribution date. Using the NUA approach, only the cost basis of shares is subject to tax at the time of the distribution from the qualified plan. The difference between the basis and the fair market value--the net unrealized appreciation--is taxed at long-term capital gains rates only when the stock is sold, regardless of the holding period. This can be a better result than rolling the stock into an IRA where all of its value will eventually be taxed as ordinary income when it is distributed to you or to your beneficiaries.

When the stock is sold, NUA is treated as a long-term capital gain, even if it is sold immediately after distribution. Any appreciation of the employer stock that occurs after it is distributed will be considered a short-term capital gain if the employer stock is held for less than one year. If the stock is held for at least one year after the transfer, it is then characterized as a long-term capital gain.

If you never sell the shares of stock with the NUA, when your beneficiaries sell the stock they inherit, they will owe long-term capital gain tax on the unrealized appreciation portion of any gain. However, since the stock receives step-up in cost basis on your death, any additional appreciation between the date of distribution and the date of your death is never subjected to income tax.

If you take the NUA approach, the shares of company stock are outside the plan and not in an IRA. They are in a regular investment account. There are no minimum distribution requirements. The higher your income tax bracket and the more the stock has appreciated, the more you may benefit from this strategy.

If you are considering this technique, ask your plan administrator for the cost basis of various lots of employer stock in your plan. It makes sense to take out shares with the lowest cost basis. You don't have to take out all the shares. You can rollover part of the shares - choosing the ones with a higher cost basis to rollover. The special NUA treatment is lost for shares that are rolled over into an IRA.

Unfortunately, many retirees and advisors assume that rolling a retirement plan distribution into an IRA is the only option available. On the surface, this seems like the standard operating procedure, but it could cost thousands of dollars in additional taxes that could have been avoided.

In order to use the NUA approach, the employee must elect a lump-sum, in-kind distribution from the plan (a complete distribution of all plan assets in a single calendar year). A lump-sum distribution can be received on the employee's death, on the employee's attaining age 59 l/2, on the employee's separation from service, or on the employee's becoming disabled. If there is company stock in your retirement plan when you die - your spouse or other beneficiaries can use the NUA strategy.

With capital gains rate at an historical low, the increased use of company stock in retirement plans, and the long-term gains of the stock market, using the NU approach makes good sense for many plan participants.

On March 23, 2009 the IRS announced a new voluntary disclosure program for undeclared foreign accounts. The "amnesty" program is open for six months, closing on September 23, 2009. For qualifying taxpayers who come forward and report their undisclosed foreign bank accounts and pay back taxes for six years plus interest and some penalty, the IRS agrees not to bring criminal charges or assess the 75% fraud penalty.

IRS Commissioner Douglas H. Shulman said, "offshore accounts harbor billions of dollars, and people should take notice that the secrecy surrounding these deals is rapidly fading."

On June 30, 2008 a federal court authorized the IRS to serve a "John Doe" civil summons on UBS, demanding the names of approximately U.S. clients who hold off-shore bank accounts. On February 18, 2009, UBS entered into a Deferred Prosecution Agreement with the Department of Justice and agreed to pay $780 million to the U.S. and to disclose the names of between 250-300 of its U.S. clients who had maintained secret accounts at UBS. Now the IRS has sued to enforce the earlier John Doe summons seeking the disclosures of the owners of about 52,000 UBS Swiss accounts. It is estimated that these accounts hold some $17.9 billion in assets. The 52,000 accounts are just at one bank in one country. No one knows how many other accounts in other jurisdictions and financial institutions are unreported.

In addition, UBS has notified many of its U.S. clients that their secret bank accounts will be terminated. Closing the accounts is going to put the account holders in a tight spot. They have two choices: 1) transfer the money to banks in other "bank secrecy" jurisdictions which would create a paper trail discoverable by the IRS, or 2) repatriate the funds to the U.S and come clean with the IRS.

It is not illegal to have a foreign bank account in a bank secrecy jurisdiction (Switzerland, Liechtenstein and the Cayman Islands come to mind). What is illegal is failing to disclose the accounts and failing to report the income and pay income tax. In addition to disclosing the existence of the accounts on your 1040 and reporting the income, Foreign Bank Account Reports ("FBARs") must be filed by any U.S. taxpayer who has signatory or other authority over a foreign account or accounts that have a combined value of more than $10,000 at any time during the calendar year.

For taxpayers who "come clean" under the voluntary disclosure program, they will have to 1) pay back taxes due on the undisclosed assets for the last six years; 2) pay interest on the back taxes; and 3) pay a 20% accuracy penalty or a 25% delinquency penalty for each tax year at issue.

While this may seem like a tough position, it is far less than what these taxpayers will face if they are discovered by the IRS. Most importantly, the IRS will not pursue charges of criminal tax evasion against taxpayers who voluntarily disclose their offshore assets under this new policy. There is no guarantee of no criminal prosecution, but it is a mitigating circumstance in whether or not the IRS will recommend prosecution and, obviously, the amnesty program is not going to work unless the IRS sticks to its announced policy.

In addition, the IRS will not pursue other penalties against participating taxpayers, such as the fraud penalty of 75% of the unpaid tax or the statutory penalty for willful failure to file an FBAR, which is the greater of $100,000 or 50% of the foreign account balance. Both of these penalties apply annually to undisclosed accounts and assets during the relevant tax years.

Since a taxpayer's name may be discovered by the enforcement of the "John Doe" summons against UBS or in Congressional Hearings, it would be prudent for affected taxpayers to begin the process of determining whether the voluntary disclosure policy is available and appropriate for their particular circumstances. As IRS Commissioner Shulman forewarned, "having the IRS find you could mean a much heavier price than coming forward on your own."

Before making a voluntary disclosure, each case should be considered by a qualified tax advisor, giving consideration to the particular circumstances of each case. Voluntary disclosure is not a guarantee of no criminal prosecution. Experts recommend that the taxpayer's attorney contact the local IRS district office. Without disclosing the taxpayer's name, the attorney should explain the facts and circumstances to the IRS to determine if the IRS will agree not to prosecute. This disclosure should only be done with a high-level IRS official or counsel.

Taxpayers with offshore noncompliance should take advantage of the amnesty and come forward. The situation is going to get worse, not better.

See Greg Herman-Giddens' post on the North Carolina Estate Planning Blog:

Deductibility of Estate Planning Legal Fees which sets forth the general rule that all legal fees for estate planning are not deductible for income tax purposes. They are only deducible to the extent that they represent tax advice (that is fess in connection with the determination, collection, or refund of any tax).

Here is an Important post about keeping copies of your tax returns from The Wandering Tax Pro :

click here

 Remember Dabby DeVito and Billy Crystal in Throw Momma from the Train?  Danny Devito is a mystery writer who has had it " up to here" with his overbearing mom.  He makes a deal with Billy Crystal.  Danny will kill Billy's ex-wife and in exchange Billy will kill Danny's mother.

When I gave seminars on the Economic Growth and Tax  Reconcilation Act of 2001 (affectaionely known as EGTRA) I would call it the "Throw Momma from the Train Act."  Why?  Because in 2009 the estate tax exemption is $3.5 million.  In 2011 the estate tax exmeption goes way down to $1 million.  In between?  In 2010 there is no estate tax at all.  So we throw momma from the train in 2010!

I was reminded of this today when I read Barry Nelson's article, "Throw Me From the Train"  at registeredrep.com.  He writes:

"The death tax repeal sunsets in 2011. What should your clients tell their families?

My message is not for the easily offended, but, in the closing months of 2008, I feel this must be said: Congress still has not done anything about the estate tax law. If Congress doesn't act very soon, each one of us should ask our clients some very hard questions: If they fall terminally ill before the end of this year, do they want to be kept on life support for additional days or months into 2009 so that their estates and families can benefit from that year's higher estate tax exemption? 

Or, if they're stricken in 2009 and Congress still fails to act, do they want doctors to keep them alive until 2010 so that they can spare their heirs the additional pain of paying estate taxes at all--since under existing law estate tax is repealed in its entirety for those dying in the year 2010?

And how about if they fall ill in 2010? Do they want their families to pull the plug before 2011 dawns and the estate tax goes back to its previous, onerous state?"

"I know this is macabre, but if estate tax legislation is not enacted before Jan. 1, 2010, then the potential savings of dying in 2010 could be enormous. Similarly, the consequences of dying in 2011 could be burdensome. Death and taxes are certain, but their dates and rates are not."

It has been a lousy year for equity mutual fund investors. According to Morningstar, the average U.S. diversified stock fund is down 33% year-to-date. Adding insult to injury, some mutual fund owners are going to have to pay hefty income tax bills on their mutual funds that lost value. Why? Because of year-end capital gain distributions. Yes, even funds that are way down may be throwing off substantial amounts of income because of sales inside the fund earlier in the year.

Some fund holders may wonder how it is possible for capital gains to be possible in a declining market. The realized gains are from stocks that were in the mutual fund portfolio, perhaps for several years, and when liquidated this year, even in a down market, still had significant gains.

In general, a mutual fund itself is not taxed if it distributes substantially all of its income (at least 98%) to its shareholders. The shareholders must report mutual fund distributions as income. Dividends and interest from holdings inside the fund, as well as any capital gains from the sales inside the fund, are taxed to the shareholders.

There are two types of mutual fund distributions: (1) ordinary dividends and (2) capital gain distributions. Ordinary dividends are taken from the dividends and interest earned inside the mutual fund and are paid out to shareholders, often quarterly. Capital gain distributions are distributions made to fund shareholders when the gains from the fund's sales of securities exceed losses. Capital gain distributions are always treated as long term capital gain, no matter how long you owned the mutual fund shares.

Since mutual funds are required to distribute at least 98% of their income annually, and since net gains and losses cannot be determined with any accuracy until near year-end, many mutual funds make their largest distributions in December. Don't buy mutual fund shares right before a December capital gain distribution. Buying mututal fund shares at this time will result in you paying tax on the distribution, which represents earnings over the course of a year in which you did not participate.

Tom Herman, writing for the Wall Street Journal, points out that despite the stock market's nose dive, many funds are likely to make year-end capital-gains distributions this year. Herman says: "That means it may be a good time to consider selling some underperforming funds before they make a taxable distribution. It also means that bargain-hunters looking to get back into the market now need to be careful. Otherwise they could be saddled with a stiff tax bill that could easily have been avoided."

If you sell fewer than all of your mutual fund shares, you need to determine what is the best way to allocate your basis among the shares. There are three approaches: 1) first-in, first-out (FIFO), 2) average cost, and 3) specific identification.

First-in, first-out assumes that the first shares you bought are the first shares you sold.

Average cost is determined by adding up the total cost of all the shares you own and dividing by the number of shares. It can be done on all shares, or in two categories, the average cost of long-term shares and the average cost of short-term shares.

If you have a record of all the purchase dates and prices of all shares you own, including shares purchased with reinvested dividends, you can pick individual shares to be sold. If you use this method you can pick out the shares that have the highest basis to be the ones you sell, thus, keeping your gain to a minium. To use this method you must indicate to the fund or your broker which shares you are selling - you can't designate them after the fact.

Your mutual fund statement may calculate gain or loss for you. The mutual fund broker usually uses the average cost method. You are not required to calculate your gain or loss using the method shown on the statement. However, once you start reporting using average cost, you have to report all future sales using that method.

Capital gains and losses can offset each other dollar-for-dollar. If your losses exceed your gains, you can deduct $3,000 of capital losses from other ordinary income. Unused losses are carried over into future years.

If you decide to sell a mutual fund to avoid the capital gain distribution and then buy it back because you like it as an investment, beware of the wash sale rules. You can't deduct losses from sales of stock in a wash sale, which occurs when you sell a stock at a loss and buy the same stock within 30 days before or after a sale.

On October 16, 2008, the IRS announced annual inflation adjustments for 2009.  The adjustments include an increase in the annual gift tax exclusion for present interest gifts to $13,000. The annual exclusion for present interest gifts to a non-citizen spouse will be $133,000.