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Kerstetter Letter®
Issue 97-3
Fall 1997
© 1/30/99 by Kerry
M. Kerstetter, MBA~CPA~ATP~ATA
This is the
complete text from the Fall 1997 issue of the Kerstetter Letter. Annual (four quarterly issues) subscriptions
to the blue-paper printed version, including all of the hilarious cartoons and
animal pictures, is available by mailing or faxing a check for $19.95 to
Kerstetter Letter, 11802 Deer Road, Harrison, AR 72601-6550 Fax:
1-800-839-3008
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1997 TAX LAW
Much to my surprise, a tax law was actually
passed and signed by the President in 1997.
Many people are pointing out my prediction in the last issue that no
such agreement would make it into law this year. How could I have been so wrong?
I guess it was because I made the foolish mistake of believing the
promises of many freshmen legislators to read any proposed law before voting on
it. The only way they were able to ram
a tax bill through this year was because they only printed up one copy of the
1,200+ page bill and nobody in the house, senate or administration was able to
read it before voting on it. This was a
golden opportunity for each of our leaders to sneak in special tax breaks for
their campaign contributors. Bill
Clinton, when asked, after he had signed the law, what items he would line item
veto, admitted that he didn’t even know what was in the law. I know that I am somewhat of an idealist,
but is it really too much to ask our elected leaders to read the legislation
before they vote on it?
I have long advised against jumping the gun
in regard to tax law changes, and how important it is to distinguish between
the real world that most of us live in and the fantasy world of
Washington. A big mistake people have been
making is assuming that because something has been promised by our leaders, it
is appropriate to act as if it has already been enacted into law. The 1995 reduction in the capital gains tax
rate that was passed by Congress is a perfect example. Many people sold property and advised others
to do so based on this legislation. As
I have explained, this was vetoed by Clinton, so the net effect was as if it
had never even been discussed by anyone in Washington. [On a side note, I am noticing that the collective
memory of the American public is becoming even worse than I had expected. My recent seminars around Arkansas had to
include some American history because there were very few people who even
remembered anything about that 1995 tax law, and even fewer recalled that it
had been vetoed. It’s very scary to
think that so many people consider something that happened only two years ago
to be such ancient history as to not be worth remembering.] As I tried to warn everyone back in 1995, a
tax law change doesn’t become real until the President signs it. I guess I need to amend that after what has
already happened with this 1997 tax law.
With the President’s new line item veto power, a tax law isn’t really
final until after his five day line item veto period has expired. Unfortunately, even that isn’t enough to be
assured that the law will remain intact.
Now that some Congresspersons have had an opportunity to possibly read
the tax law, or have its contents explained to them, more than a month after it
has been signed into law, and the different constituencies start bitching about
the things they don’t like, they have already begun undoing various components,
starting with the special tax break that was slipped in for the tobacco
companies. This seems like a new record
for changing their minds. In the past,
Congress wouldn’t get around to reversing its own tax legislation for at least
a year or two. They have proven that
even after a law has been signed by the President, nobody can rest assured that
it will not be messed with at any time, including retroactively.
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BUDGET SURPLUS
What’s most ridiculous is the fact that the
Washington bureaucrats are predicting a budget surplus by the year 2002 and have
now started a debate as to what should be done with that extra money; pay down
the debt, spend it on more government programs, or give it back to the
taxpayers. Nothing could be more
premature than this because any serious analyst of Washington (as I am) knows
that all of the financial predictions for the next several years consist of
smoke, mirrors, unreasonable assumptions, and outright SWAGs (Scientific Wild
Ass Guesses), such as the stock market continuing to rise by 45% a year
indefinitely. These are as realistic as
are all of the dire forecasts for huge weather catastrophes in the next few
years based on the expected El Nińo in the Pacific Ocean. The boneheads in the media, who have
abandoned all aspects of objectivity and independent verification, report these
predictions as if they are facts. It
used to be that reporters cared about the truth and independently verified
every detail before printing it. My
respect for the Wall Street Journal continues to wane as it wastes valuable
space covering the discussions over the budget surplus as real news and not
satire. Is it any wonder that so many
people believe in government cover-ups and conspiracies when we are lied to
about such obviously bogus information?
Most of the results of the law are no
surprise. As with any effort by the
federal government to solve a problem, they aimed their bazooka backwards. The official name of the new law is the
“Taxpayer Relief Act of 1997.” Most
people are giving it the more appropriate moniker of the “Tax Complication Act
of 1997.” With all of the discussion
for the need to simplify taxes, our leaders have given us the biggest mess
since the 1986 overhaul of the tax code.
I realize that many people think that tax professionals lobby Congress
to make things complicated so that we will have more work. Actually, the opposite is true. For decades, the AICPA and other groups
representing tax practitioners have lobbied Congress to keep its hands off the
tax laws long enough for the public to understand them. The constant tinkering with the rules makes
it literally impossible for anyone in the public or the IRS to fully comprehend
how things should be done. As always,
Congress refused to keep its hands off and they have given us the messiest
change to the tax code in a long time.
With each provision of this new law having different effective dates and
long drawn out phase-ins, I have already noticed several that are so
complicated and drawn out that they are practically unenforceable by IRS. If we in the tax practitioner community had
tried to complicate the tax rules, we couldn’t have done a better job than our
leaders did in their 1,200+ pages.
Before the bill had even been signed, the
misinterpretations by the press and the public had begun. I devoted the first half of each of my
September seminars to explaining some of the more important, and misunderstood,
aspects of the new tax law. Just
another reminder of how dangerous it is to rely on the mass media for information. The folks in the “old media” (print and
broadcast) love to point out the instances when someone in the “new
media”(Internet and talk radio) makes a mistake. They completely ignore the fact that their own information is
becoming less and less accurate by the day, because of their own political and
social agendas that they try to force on the public as fact, as well as the
effect of the overall dumbing down of the population. More and more of the reporters can barely read the news, much
less understand what it means. While
examples are a daily occurrence, what I heard a few months ago on a
Springfield, Missouri’s local newscast is a perfect illustration. It was a Saturday, so the second stringers
were working. The weekend anchor, who
was obviously hired for her telegenic attributes & not her Mensa
membership, was reading a cutesy story about Venice, Italy. I don’t remember anything of what the story
was about because I was so flabbergasted to hear her pronounce the name of the
city the same as Venus. I realize I am
overly picky when it comes to the use of the English language, but am I wrong
to expect a professional communicator to understand the difference between
Venice and Venus?
Another reminder as to where to look for tax
advice. There will be speakers and
writers from IRS commenting on this new tax law. Some service clubs routinely invite representatives from IRS to
update their members on new tax law changes.
This is absolutely counter-productive.
First, even if the IRS people actually understood the laws, they are not
in the business of telling people how to reduce their taxes. They are in the business of squeezing money
out of people. It is a conflict of interest from the start. Next is the fact that IRS auditors love to
tell everyone that they don’t have to know current tax laws. They come in a few years after a return is
filed and try to find mistakes. There’s
no way that they could tell you ahead of time how to properly comply with the
tax laws. I work with IRS auditors all
the time and they gleefully admit this and even understand how ironic it
is. They can’t tell you ahead of time
how to do things correctly; but by gosh, they’ll be ready to come in after the
fact to point out how you screwed something up.
As usual, this law included a good selection
of special tax breaks for big campaign contributors. I prefer the term that rhymes with a group of American Indians
(tribe), but that’s not politically correct nowadays. However, as I have discussed on several occasions, it is amazing
how inexpensive it is to bribe a Senator, Congressperson or President. For a few thousand dollars in campaign
contributions, they will provide special tax breaks worth millions. Contributions in the millions earn tax
breaks in the billions. That kind of
risk free guaranteed return on one’s investment is unavailable anywhere else.
I’ll discuss some of the more important
changes in the tax law, along with how to best exploit their money savings
opportunities. Future issues will delve
into other areas. You need to always
keep in mind that any provision in this tax law is not guaranteed to last
forever. Congress has never been able
to resist the temptation to tinker with the tax code, especially if it looks
like people are actually starting to understand it.
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CAPITAL GAINS
This was a big surprise to me after all of
the similarities to the 1995 capital gains cuts and the persistent propaganda
permeating this country as to the character of capital gains (e.g. only earned
by the evil rich). However, it isn’t
anywhere as clean a change as was promised or as most people believe.
First, the definition of how long an asset
must be held to qualify for special long term gains treatment has been
changed. It has now been extended from
12 months to 18. In addition, there are
some special transition dates and rules that will make preparing 1997 tax
returns extremely complicated, to say nothing of the special modifications that
will be required on Schedule D.
Assets (securities, real estate, businesses
& most other investments) sold prior to May 7, 1997, which had been held
for over 12 months, will be subject to the prior law’s maximum income tax rate
of 28%. Assets that had been held at
least 12 months and were sold between May 7 and July 28, 1997 will have a
maximum tax rate of 20%. For sales
after July 28, 1997, the top rate is 28% if the asset was held between 12 and
18 months and 20% if the asset was held more than 18 months.
There is an even bigger special tax break
for those people whose other income would have only been taxed at the lowest
15% rate. They will pay a maximum of
10% on long term (over 18 months) gains realized after May 7, 1997. This is yet another reason to take steps,
such as setting up a C corporation, to keep your individual taxable income from
rising above the 15% threshold.
Long term gains on the sales of collectibles
will still be subject to a 28% maximum tax rate. These include art, antiques, gems, metals, stamps, coins,
bullion, alcoholic beverages, comic books and baseball cards.
Depreciable real estate has a very expensive
difference when computing the capital gains tax. The depreciation recapture is subject to a maximum tax rate of
25%, up to the full amount of the depreciation claimed. Don’t try to avoid this by not claiming
depreciation because IRS is allowed to reduce a property’s basis (and increase
the gain) by the amount of depreciation that was allowable. If you don’t need a big depreciation
deduction, you can opt for a longer life (e.g. 40 years) that will reduce the
depreciation recapture. However, if you
claim nothing, an IRS auditor will compute the highest depreciation
possible.
In regard to the holding period for property
acquired as the second (replacement) leg of a tax deferred exchange, there is
an often overlooked opportunity.
Because the cost basis of the old property has been rolled into the new
property, you are also allowed to add on the old property’s holding period to
the time you have actually owned the new property. This makes many more people eligible for the special long term
(over 18 months) tax rate than would otherwise think so.
Now for something handled consistently. For installment sales, any capital gains
proceeds received after May 7, 1997 will use the new tax rates, even if the
original sale took place prior to that magic date. Some advance warning for 1997 tax returns. Persons receiving payments on installment
notes will need to keep track of the total principal received from January 1,
1997 through May 7, 1997 and the total principal received from May 8 through
December 31, 1997. The interest
collected is all taxed as ordinary income, so no special accounting is required
for it.
These tax rates are only for federal
individual income taxes. There have
been no changes to state tax rates or to federal corporate rates. The other hidden taxes that are triggered by
large capital gains (e.g. loss of deductions and exemptions, taxation of Social
Security benefits) will still apply.
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PRIMARY RESIDENCES
I must admit that this promised tax break
seemed far too good to be true and I didn’t expect it to survive intact. I was wrong and am now working to help
people use it to its maximum by playing the conversion game. I’ll recap the new rules here. They took effect for sales after May 6,
1997.
Amount - The maximum gain to be excluded tax free
is $250,000 per person and $500,000 per married couple. Title companies will no longer have to
report property sales of up to $250,000 per person or $500,000 per couple on a
1099-S to IRS if the sellers sign an affidavit that the property was their
primary residence.
Record Keeping -
While this has been touted as removing the need to keep records of how
much you have invested in your home, I think it is still important to keep all
of your figures. The gain could still
be taxable by the state, so you would want to document as high a cost basis as
possible. Likewise, if the home is
converted to rental, depreciation deductions will be based on the actual cost
basis. There is also a likelihood that
this tax break will be deemed as too generous and repealed in a few years.
Age – There is no longer a need to hold off
selling homes until after one’s 55th birthday because there is now
no minimum age to qualify. Even those
folks who used the one time exclusion previously are eligible to exclude
additional gains.
Residency – You must have owned and lived in
the home at least two of the five years prior to its sale. This allows you to rent out a prior
residence, claiming all of the tax deductions for rental property, for up to
three years prior to the home’s sale.
This exclusion can be used no more than once in a two year period except
for cases of illness or job changes, in which case the maximum exclusion amount
is pro-rated.
Rollover Rule – The rule allowing a gain to be
rolled over into a new home of equal or higher cost is now history. It has been repealed as of sales after
August 4, 1997, unless a new replacement residence was acquired before August
6. This will only be a problem for
those with gains over the $250,000 per person limit, a group that has long been
a target for Washington taxers. People
in that situation may want to consider converting their homes to rentals and
using the 1031 exchange rules to defer all of the gain, or at least carrying
back part of the sales price to defer part of the gain into future years.
MIXED USE PROPERTY – This new larger
exclusion will change somewhat the strategy for selling mixed use
property. These are most often
properties that include both a primary residence and farm, rental or business
property. Since most often these properties
are sold for a package price, the tax treatment depends on the allocation of
the price between the residence and business portions. Up to $500,000 of profit from the residence
portion can be tax free, and the profit on the business portion can be deferred
by reinvesting into other business or investment property under Section 1031. Despite common belief, there is no maximum
size of property that qualifies as a primary residence. It is the use of the property prior to its
sale that matters, not how large it is.
A farm that has been deactivated and used as a primary residence for at
least two years prior to its sale could qualify for the tax free gain on
residence sales. Same thing for rental
duplexes and triplexes, where the rental units have been converted to personal
usage.
SERIAL HOME SELLING
As I mentioned a few times earlier, playing the
Conversion Game by moving into rental properties for two years and selling them
as primary residences can generate a ton of tax free income. Many other people are also picking up on
this strategy, and it has been given the name “Serial Home Selling.” Just as a serial killer murders one person
after another, these folks will be selling one home after another. The question has come up often as to how
best to exploit the full potential of serial home selling, especially if a
person owns several rental properties.
Specifically, should s/he wait until the end to sell the one with the
highest capital gain, or do it as early as possible? I ask this question. If a
person has a dozen rental homes, how long would it take to liquidate them all
under this plan of serial selling?
Living in each for at least two years, it would take 24 years to sell
them all off. Now my next question. How likely do you think it is that Congress
will keep this provision of the law intact for the next 24 years? If you think it is possible for Congress to
keep its hands off this specific tax break, just sell your rentals in whatever
order you feel like. If you are as
skeptical (realistic) as I am, you should be aware that Congress could very
easily repeal this new rule at any time, especially if they see it being used
in unintended ways, such as to benefit evil landlords. Therefore, it would probably be most prudent
to try to sell off the rentals with the largest profits as soon as
possible. As I have explained before,
this will require an analysis of your detailed depreciation schedule. If those high gain properties are not the
most desirable locations to live in, you may want to consider using tax
deferred (1031, Starker) exchanges to acquire properties that you could
tolerate living in for two years. The
new tax law did not make any changes to the rules for exchanges.
An idea that one seminar attendee had to
speed up the process was to give rental homes to kids or other family members
to live in and sell. Since the basis of
gifted property for the recipient is the giver’s basis, this strategy would
essentially allow potential capital gains to be transferred to others, who
could utilize the new tax free exemption on most home sales. Possible gift taxes should definitely be
evaluated before undertaking this approach.
MARKET
EFFECT
The effect of these capital gains tax changes on the
real estate market will be interesting.
At first blush, many people think they will help the market. As I always like to take a much longer range
perspective than do others, I’m not so sure.
It has long been acknowledged that there are trillions of dollars of
property that people were hoping to sell once the tax rate was reduced. If these are put on the market all at the
same time, the good old supply and demand equation will kick in and the market
values of properties will drop. While
prudent investors will take their time to open the spigot slowly and not disrupt
the market too much, there has already been speculation over exactly how long
these lower tax rates will remain. More
people are aware that what our esteemed leaders in Washington giveth, they can
taketh away. Waiting for five years to
sell off highly appreciated property would be a naďve move.
The other factor to consider is that with the repeal of
the residence rollover rule, people will no longer have any requirement to
overspend for their new homes. Property
values in areas like here in the Ozarks could be affected. The rapid appreciation in property values
over the past decade was driven by the need for transplants to pay high prices
for their new homes. With no such
obligation, new immigrants will most likely start paying more realistic prices
for homes. It will also allow many people
to realize their goals of selling a mortgaged property and buying a new home
for all cash. Under the prior rules,
these folks were forced to take on a new mortgage in order to buy a more
expensive home than they really wanted, or hold off selling completely.
I have already had some local Realtors dispute this
economic theory of mine with their idea that, removing the requirement to buy
expensive homes, more people will be drawn to this lower cost area rather than
more expensive parts of the country; thus increasing demand. As an Ozark property owner, I hope this is
true; but only time will tell.
STATE
TAXES
Now that the federal capital gains tax rates have been
dramatically reduced and eliminated for many sellers, the state income taxes
become even larger components of the total tax bite. There are a few states that base their income taxes as a
percentage of the federal income tax figures.
Most states, however, have their own tax rules and rates. I am not aware of any of state so far that
has followed the federal lead. So,
while a home sale may be exempt from federal income tax, it will still be
subject to state income tax, which could be as high as 12%, depending on your
state’s tax rate structure. The
rollover rule, with a replacement home of equal or higher cost, may still be
beneficial.
IRA WITHDRAWALS
After more than 10 years of promising to
make IRA withdrawals penalty free for certain special uses, some provisions
have finally gotten through. Starting in 1998, there will be no 10%
federal early withdrawal penalty for some money taken out of IRA accounts. Up to $10,000 can be taken out penalty free
for the purchase of a first home by yourself, your children or your
grandchildren. The money has to be
spent on the home within 120 days of the withdrawal. The definition of a first time homebuyer has been set rather
generously. Anyone who hasn’t owned a
home within two years before buying a new one.
This will be a big benefit for divorced folks. Any amount can be withdrawn penalty free for the payment of costs
of higher education for yourself, your spouse, child or grandchild.
Please remember that this is only a waiver
of the 10% federal early withdrawal penalty.
Income taxes, and state penalties will still apply. Depending on your tax brackets, there may be
less expensive sources of money, such as credit card advances.
This new provision also only applies to IRA
accounts and is not to be used with other kinds of retirement plans, such as
401(k), 403(b) and company pension plans.
As always, there is a way around this restriction. If you roll over money from the other kinds
of accounts into an IRA, you would be able to take advantage of this new
opportunity.
PENALTY ON EXCESS DISTRIBUTIONS
The three year (1997-98-99) suspension of
the 15% surtax on overly large distributions from retirement accounts has been
made permanent. This really isn’t that
surprising considering the growing political strength of senior citizens in
this country. This change does mean
that people who may have had to face this penalty in the past should make
appropriate changes in their estate plans.
The various tactics that had been used to avoid or minimize this penalty
may no longer be the best overall strategy.
ESTATE TAXES
Although the $600,000 per person exclusion
from gift and estate tax was established in the early 1980s, the promised
inflation adjustment lost again amid the rhetoric from those who believe in
redistribution of all income and wealth (who used to be called Communists). The administration’s representatives told
Congress that anyone who wants to protect his estate from taxation is just
plain selfish. Congress has been
bragging about increasing this exclusion to a million dollars. As with most information from Washington,
it’s not exactly true because the excludable amount will go up in small
increments over the next several years.
We do have to be thankful for small favors. The $600,000 exclusion limit will creep up to $625,000 in 1998; then $650,000 in 1999, $675,000 in 2000, $700,000
in 2002, $850,000 in 2004, $950,000 in 2005, and $1,000,000 in 2006, where it will
probably stay for another dozen years.
The moral of this story is a good one - live as long as you can because
the later you die, the more of your estate will escape the government’s
clutches.
Estates containing businesses and farms have
an even larger exemption potential. In
1998, up to $1,300,000 of a decedent’s estate will be exempt from estate tax if
the business or farm makes up more than half of the value of the estate. This is a total of $1,300,000 and includes
the $600,000+ that everyone else receives.
There are also several restrictions on the use of the business property
by the heirs.
Part
or all of the estate taxes saved by this extra exemption will have to be repaid
if:
·
The
heir disposes of any portion of the inherited business interest within 10
years.
·
The
heir doesn’t materially participate in the business for a total of at least 5
years during the 8 years after the decedent’s death.
·
The
heir loses United States citizenship within 10 years.
·
The
principal place of business moves outside the United States within 10 years.
While some
advisors are already claiming that these restrictions are so cumbersome to
comply with that they may forgo the larger exemption, I see it a bit
differently (as always). I don’t think
these restrictions are enforceable. If
you were to ask IRS for a copy of a five year old tax return, they couldn’t
send it to you. They only keep four
years of returns in their warehouses.
Keeping tabs on a business for eight or ten years after the previous
owner’s death is going to be impossible.
With the pace of change in the business world growing ever faster, I
don’t see how a business can be recognized ten years later, much less keeping
track of each individual business asset.
EMPLOYER EDUCATION ASSISTANCE
As everyone
expected, the special tax break allowing an employer to pay up to $5,250 per
year of an employee’s non-work related educational costs has been retroactively
reinstated; this time through May 2000.
A new restriction – most graduate school courses no longer qualify.
DONATING COMPUTER ITEMS
For two years
(1998 & 1999), there will be an increased deduction available to
corporations who donate computer hardware, software and fiber optic cable to
elementary and secondary (K-12) educational charitable organizations or to
private foundations that donate those items to the educational organizations
within 30 days. Normally, such a
charitable contribution deduction is limited to the book value of the asset,
which is decreased for depreciation that has been claimed. For the next two years, corporations will be
able to deduct the actual full cost of computer items that are donated within
two years after acquisition, even if they have been partially or completely
depreciated. For assets expensed under
Section 179, this could result in deducting the cost of computer items
twice. With the pace of change in
computers continuing to increase, this will encourage faster upgrading of
equipment at the corporate level, with the hand me downs going to schools. This looks like a win-win opportunity and
may have some tax planning repercussions in regard to whether specific
equipment should be purchased by an individual or by his/her corporation, a
common question.
JUST THE BEGINNING
A reminder: any tax break with a delayed enactment can
always be removed or changed before it takes effect. Our illustrious leaders have never had any qualms about reneging
on promised tax breaks. These topics
just scratch the surface of this complex tax law. I will be discussing other facets of it in future issues. If there are any specific topics that you
have questions on, please let me know.
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MEAN
TESTING
As I have been
warning for a long time, the government has continued to expand its use of what
it calls “Means Testing” when deciding how to allocate government benefits and
tax breaks. This is nothing more than
another intensified attack on middle class people. Their rationale is that if you have other means of financial
support, such as a lot of wealth or income, you won’t be provided with the same
benefits as other, less fortunate, Americans.
I prefer to call it “Mean Testing,” with our leaders being mean to those
who may make more money than they should be.
The list of phase-outs of tax breaks for people making more than a
certain amount of money has grown by leaps and bounds with this new tax law,
and has no sign of getting better. A recent
issue of Forbes magazine had a full page of the mean testing restrictions. They acknowledged that there were many more,
but that was all they had space for.
Understanding the
problem and then doing something about it are what separate the whiners from
the doers. Most people will play the
same hand they have been, and do nothing, letting the government take their
wealth away from them. The few who
recognize that “if it is to be, it’s up to me,” will take steps to protect
themselves.
As soon as Clinton
announced his $1,500 new Medicare tax on people making over $50,000 AGI
(adjusted gross income), I started thinking of ways around this. The most obvious is the same method of
staying in the 15% tax bracket in order to obtain the 10% long term capital
gains rate; to use a C corporation to siphon off some income from the 1040 and
utilize the corporation’s $50,000 15% bracket.
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What is very scary
is the fact that IRS auditors are examining tax returns without having the
foggiest idea of the real rules. Most
people assume IRS agents to be the world’s top experts on taxes. I have had to teach, one on one, several
auditors the rules for tax deferred like kind exchanges (aka Starker &
1031). Most of them have the same
misconceptions as held by many in the general public, especially the like kind
definition for real estate. I have also
found myself having to teach IRS auditors what are allowable deductions and the
appropriate documentation for them.
IRS doesn’t pay me
anything for teaching their agents the rules, and I haven’t billed my clients
for this time. I see it as an
investment in building a foundation for easier audits down the road.
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It has long been
my contention that one reason for the decline in American civilization is the
reduced emphasis on education. It is
also my theory that this is not coincidental or by accident. There has been a concerted effort in the
government run schools to de-emphasize education as a priority. American history and civics are gone from
many school curricula; so is it any wonder why so few people understand how our
government is supposed to work?
One of the
scariest things I hear is the ABC News self promotion where they say “More people get their news from ABC News
than from any other source.” If
that’s true, it’s no secret why more and more Americans are ignorant.
Another indicator of priorities
is a recent development in Arkansas.
Since 1993, the state Board of Education started requiring students to
maintain at least a 2.0 (C) grade point average in order to be eligible to
participate in athletics. I guess it is
too tough to walk and chew gum at the same time, because they are now seriously
discussing eliminating this requirement.
Here in the South, sports are a religion, obviously more important than
scholastics. Proponents of this change
say that not everyone is cut out to be an academic, so it is crazy to require
that they maintain a C average.
This sends a very
clear message to students. What makes
this even more ludicrous is the fact that a 2.0 GPA is even easier than ever to
attain. I discovered a year ago that 4.0
is no longer the highest GPA possible, when some high school students were
introducing themselves to our Rotary club and mentioning GPAs higher than
4.0. I was told that they receive bonus
points for extra curricular activities.
Since the GPA has now been watered down, that makes it even more
ridiculous.
This dumbing down
of the American population is not accidental, and it affects us all, whether we
have kids or not. Our leaders know all
too well that knowledge is power and are making sure that as many people as possible
are ill informed and ignorant so they can be easily controlled. I continue to admire and support those
parents who home school their kids and/or have them at the few non government
controlled schools.
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IRS CHECK
OF PROSPECTIVE SPOUSES
Time for another mention of
this goodie. When you marry someone,
you assume personal and financial responsibility for your new spouse’s tax
obligations. IRS has been allowed to
ignore all of the constitutional protections we are supposed to have. IRS is also allowed to ignore otherwise
legally binding contracts and agreements, such as pre-nuptial and divorce
agreements.
I have seen the issue of huge
prior year tax bills destroy marriages, decimate the innocent spouses’
finances, and lead to actual deaths due to stress (heart attacks, strokes, and
suicides).
Obviously, you hope your
prospective spouse will be honest when you ask whether or not s/he has filed
all tax returns and paid all taxes; but you have to remember to ask the
question. If s/he lies to you in regard
to this issue, you probably won’t be married for very long. IRS has a special form for employers, mainly
law & CPA firms, to check whether their employees have filed their tax
returns. Maybe it’s time for such a
form for prospective spouses.
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A large potential tax
deduction that is underutilized is the Section 179 expensing election. This allows the cost of new business
equipment to be deducted immediately in the year in which it is placed in
service rather than depreciated over several years. The maximum amount of this deduction is increasing based on the
following schedule. The years are when
a tax year begins. For individuals, on
the calendar tax year, it is straight forward.
For corporations with a fiscal year other than December 31, the
applicable amount is the one for the year in which the fiscal year begins. For example, a tax return for the year ended
June 30, 1998 could claim a maximum §179 deduction of $18,000.
1996 $17,500 1997 $18,000
1998 $18,500 1999 $19,000
2000 $20,000 2001 $24,000
2002 $24,000 2003 $25,000
I know many people budget their
equipment purchases based on these annual limits. I want to clear up some misconceptions and give some money saving
suggestions. There are some who believe
that if you pay for a new asset before the end of your tax year, you are
entitled to claim the deduction. That
is not true. The asset must be placed
into service in your business before the end of your tax year in order to
qualify.
The types of
assets that qualify for this deduction are those that used to qualify for the
investment tax credit before Congress took that away. Namely, they have to be movable.
Real estate does not qualify.
Vehicles don’t qualify unless they are over 6,000 pounds gross vehicle
weight.
Since partnerships
(1065) and S corporations (1120S) don’t pay income taxes, their §179 deductions
are passed through to their partners and shareholders on their K-1
schedules. On the partners’ and
shareholders’ individual tax returns (1040), they are limited to the one
maximum amount (e.g. $18,000 for 1997) even if there were more qualifying
assets purchased for a Schedule C business in addition to the 1065 &
1120S. The marriage penalty is in
effect here as well. The maximum is per
person or per couple. A couple with a
tax divorce could double their maximum deduction. A C corporation (1120) can also claim its own §179
deduction. A person with a closely held
C corporation could deduct as much as $36,000 for a 1997 §179 expense by
purchasing some equipment through the corporation and some through the personal
Schedule C business. A couple with a
tax divorce, where each person owns a corporation, could conceivably deduct up
to $72,000 for their 1997 §179 deduction.
I call this a multiplier effect, which will obviously get much larger in
the next few years ($100,000 for 2003 tax returns).
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One of my biggest
goals in regard to saving money for clients is with reducing or eliminating the
thousands of dollars paid into the federal government’s Ponzi scheme known as
Social Security, as well as to maximize the Social Security benefits received
by those lucky enough to do so. For as
long as I have been in the tax business, a common approach to accomplishing
both of these goals has been to receive income that is not what IRS and the
Social Security Administration consider as “earned” income, which is for
personal services rendered. Lease
income is technically earned by the asset leased, so it is not subject to
social security taxes or count against benefit recipients. The same thing for interest income.
Since the amounts
of money that we need to change from earned to unearned income has been growing
over the years, I am always looking for new ways to do this. One very effective method I have started
using this year is to have people with closely held corporations earn royalties
for the usage of their name, their business operating format and their business
contacts. As long as these royalty
payments are not for services rendered and just for the rights to use these
intangible assets, they are reported on the individuals’ Schedule E and are not
subject to any social security taxes.
They also do not count against the SSA’s limit on the earned income a
person under 70 can receive in a year.
People with ownership interests in several businesses could charge
royalties to each one. Compensation
arrangements I have seen range from a fixed amount per month to a percentage of
the gross revenues.
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OUT OF
STATE TRUSTS
In an attempt to
capture some of the offshore trust business, two states (Alaska & Delaware)
have established procedures for setting up the same kinds of trusts within
their borders. There has been a lot of
publicity about how this eliminates the need to move assets out of the country
for protection. I have serious doubts
as to whether they can live up to their billing as equal, since they are still
within the USA borders and still subject to seizure by IRS and other ruthless
federal agencies; so I would hold off using this approach until we can be sure
that it will really work as advertised..
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PLANNING
AHEAD
In the last issue,
I described how important it is for the financial spouses to organize their
information so that their non-financial spouses will be able to take care of
things after they die. I don’t have any
official statistics on which spouse is more likely to die first; but it has
been my experience that, more often than not, it is the financial spouse who
goes first. This leaves a mess for the
other spouse who, normally by choice, wasn’t very informed on the couple’s
financial affairs. Besides the sheer
stress this puts on the surviving spouse, it is a well known fact that billions
of dollars of assets go unclaimed every year.
It is hard to keep track of all the bank accounts and insurance policies
that could be floating around.
In that article, I
advised using a program such as Quicken to keep the household finances up to
date. While that should record many of
the important details, there are a lot of other things, such as insurance
policies and names of people to contact, that really don’t fit into Quicken. I didn’t have any other special format to
recommend at that time. As luck, and
Murphy’s Law, would have it, right after I had sent the Summer issue to the
printer, I found the absolute perfect vehicle to use for assembling all of
one’s important information. It is a
very comprehensive 148 page workbook called “What You Need To Know About Me”
produced by Arthur Esbin in New York.
It sells for a mere $20. In
fact, I liked it so much that I purchased two cases of them to sell to people
at my seminars so that they could avoid postage costs. I still have a few left if anyone wants to
buy it from me. Please add an extra
$3.00 if you want it mailed to you.
You can also
purchase the book directly from Mr. Esbin by sending $20, plus $3.00 for
postage, to him at: Plan Ahead Press, 780 Park Lane, East Meadow, NY,
11554-4509. His phone number is
516-483-8091. He does offer discounts
for large volume purchases. These books
would make very appropriate gifts for the clients of the many accountants and
financial advisors who subscribe to the Kerstetter Letter in case you were
trying to think of something different than the normal calendar and football
schedule.
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COMPUTERS
There has long been a lot of
speculation over when the next new and improved version of Microsoft Windows
would be released. Many people believed
the initial target date of mid-1997.
Considering that Windows 95, which was originally scheduled for release
in mid 1994, wasn’t released to the public until August 1995, Microsoft is very
consistent. Windows 98, as it is now
formally known (formerly code named Memphis), is scheduled for release to the
public in the middle of 1998. I am
waiting for a few more revisions before I start beta testing it. Microsoft also recently announced that they
are no longer selling Windows 3.1, although they will continue to sell 3.11 for
Workgroups.
While I’m on the subject of
computers, I just want to toss in my two cents regarding the year 2000
issue. This is an extremely overblown
story, and will get even more hysterical as we get closer to December 31,
1999. While it is a very real problem
for large main frame computers running older software, it is really not going
to be that big a deal for small microcomputers, especially those with Windows
95, which has always used four digits for years. My main concern here is that the scam artists will be popping up
any time now to try to exploit the public’s fears over this “crisis” and will
be offering to fix it for you. Stay
away from those scamsters.
Video conferencing through the
Internet is becoming more and more usable and much less expensive by the
day. I am looking forward to the near
future when I will be able to have face to face meetings with people all over
the world without having to leave my mountaintop; a dream come true for
me. I’m waiting for an increase in the
data speed of our local ISP. I am
interested in hearing reports from anyone who has already started using
Internet video conferencing.
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REFORMING
IRS
A lot of folks are
asking when I think we will see the last of the IRS; when the income tax system
will be repealed and replaced with something much simpler to administer, such
as a national sales tax. Unfortunately,
as much as I agree with the need to make such drastic changes, I don’t see it
happening between now and the time the sun burns out. A national sales tax is being criticized as too “regressive” for
poor people and beneficial for evil rich folks. Anything that helps the evil rich is a very difficult sell.
What I find more
revealing is the hype surrounding the Senate hearings on how IRS treats
American taxpayers. Senate Majority
Leader Trent Lott expresses amazement that IRS may be actually mistreating innocent
people in its desire to squeeze more money out of them. My question to Senator Lott is: “what planet
have you been living on for the past 30 years?” Everyone knows that IRS is out of control. What nobody wants to face up to is the
underlying reason for the IRS abuses.
The common perception that these problems are generated from inside the
IRS is completely wrong. IRS stomps all
over people, and forces many to kill themselves, because it has been given the
mandate by Congress and the Executive branch to squeeze as much money out of
people as they can regardless of the consequences to the people and regardless
of what the Constitution says. The
safety check on our constitutional rights, the Supreme Court, has also caved in
and has consistently ruled that money for the federal government is far more
important than any right or protection in the Constitution. As I have long advised, the easiest way to
reform the IRS and the tax system in this country is very straight
forward. Just make the U.S. Constitution
apply to tax laws. Unfortunately, this
conflicts with the government’s need for money and has slim chance of ever
being implemented.
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GETTING
OLDER
I don’t know if I
am just losing touch with mainstream thinking or what. Almost every day, especially when radio
stations announce birthdays, someone whines about getting older and such
terrible experiences as turning 40. I
just don’t see what’s so bad about getting older. Life itself is a deadly experience and I actually believe we
should feel a sense of accomplishment to have been able to survive another
day. For those who think it’s terrible
to turn 40, 50 or whatever age, there have been millions of people who never
accomplished that, and I’m sure wish that they could have. With all of her fame and fortune, Princess
Diana wasn’t able to make it past 36.
The only people who don’t get any older are the dead ones.
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MINIMUM
WAGE
On September 1, the federally
mandated minimum wage was raised to $5.15 per hour. All of the media reports, both local and national, referred to
this as such a great thing that so many people were receiving a pay raise
thanks to Uncle Sam. I’m sure most of
those reporters are so illiterate as to how our economy functions that they
truly believed that this extra money is coming from Washington. I did not hear a single mention of the extra
costs to the businesses that are now forced to pay more for their lower rung
workers. Of course, I shouldn’t really
have expected to. It is not politically
correct to show any kind of sympathy towards evil capitalists who may want to
control their costs and heaven forbid, actually earn a profit. It’s also too much to expect the media to
follow the chain of events through the natural conclusion. Forcing the cost of lower rung employees up
will make it so that employers will be able to afford to employ fewer of them,
hiring less workers or even laying off some.
When I tried to explain this during my recent seminars, it was met with
a similar level of apathy that has me wondering if anyone really understands
what the capitalistic free market economy is supposed to look like. Please keep this in mind as Senator Edward
(Trust Fund) Kennedy continues his push for a $7.50 per hour minimum wage.
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RETIREMENT
INVESTING
With the recent boom in the
stock market, especially with some IPOs (Initial Public Offerings), I have had
some clients earning some hefty short term capital gains. Since these were held for less than 12
months, the 28% ceiling on the federal income tax rate didn’t apply. What I have noticed is that many of these
clients could have made these investments without the need to currently pay any
income taxes. How so? They have retirement plans that have been
invested in plain-Jane CDs and other low yielding investments.
The way most
retirement plans (IRA, SEP, Keogh, 401(k), 403(b), employer pensions) work is
that all of their income, regardless of the source, is not currently
taxed. The beneficiary is required to
pay income tax on the withdrawals as they are made in his/her retirement years. The best tax savings scenario is for the
retirement accounts to be funded and invested during the years in which the
person is in the high tax brackets (e.g. 39.6%) and then draw the money out
slowly, in small increments, so that s/he is in a lower tax bracket (e.g. 15%).
There are several allowable alternative
investments, including real estate and stocks.
The best way to choose which things to invest with retirement money or
with your own after tax dollars is to project whether it will generate an
increase or a decrease to your taxable income.
Rental property normally generates deductible losses that would be best
utilized currently against your other types of income. On the other hand, investments in deeds of
trusts and other loans, such as to your corporation, would generate pure
taxable profit that would be best sheltered under the umbrella of the
retirement account.
Now that the
holding period for the preferential long term capital gain tax rate has been
lengthened to 18 months, it is more important to consider making short term
investments under the tax deferred umbrella of a retirement account.
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DEBIT CARDS
The banks and
credit card companies are increasing their push for people to use their debits
cards. These will deduct purchases
immediately from users’ bank accounts.
While I admit to enjoying the benefits of new technology, I don’t
automatically jump onto every new fangled thing that comes out. Debit cards scare me. While the companies are currently working on
ways to protect users from unauthorized usage of debit cards, and limiting
their exposure in case of stolen cards, I don’t see how that will ease my
concerns. With an erroneous credit card
charge, you have a virtual buffer zone before it costs you actual dollars. If someone were to use my debit card
erroneously (accidentally or otherwise), there is no such buffer zone. It often takes a few months to resolve a
bogus credit card charge. I can live
with that delay because I can use other cards in the mean time. I don’t think I would be able to survive as
well waiting two months for a resolution of an improper use of a debit card
that took real money out of my account.
I am very interested in hearing from anyone who is actually using a
debit card as to how they cope with this potential problem.
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Most people with
pets like to joke about their being dependents and how they should be able to
claim them on their tax returns in the same manner as for human
dependents. Actually, there is a way to
deduct the costs associated with animals, such as purchase, food, vet and other
supply costs, if you consider your animal to be a worker in your small business. While we obviously deduct all of the costs
for all of our critters here at the KMK Ranch, it isn’t necessary to have a
farming operation in order to justify it.
Dogs have long been excellent for providing security services for all
kinds of businesses; some more than others, obviously. If you were to hire an outside professional
security service to protect your computers and other business assets, you would
be able to deduct those costs. If your
dogs provide those same services, why shouldn’t you deduct their costs? Similarly, cats provide a considerable
amount of professional services, despite their reputations. Although it is true that they sleep 20 hours
a day, they pack a lot of activity into the four hours they are awake. Before we increased our cat population
considerably, we were constantly having wires shorted out in our homes and
vehicles from rodents (mice and chipmunks) eating the insulation. They chewed holes in the fuel line of my big
Honda motorcycle. They chewed up
important papers that were in storage.
They left unsanitary droppings all over the place and were eating the
special feed we have for our sheep, goats and llamas. Since we put our cats to work, we haven’t had these
problems. How much would it have cost
us to hire a professional exterminator?
What about the health effects of the poisons and chemicals, especially
considering that we have always operated our ranches as organically as
possible?
If you think
creatively enough (the key to maximizing tax deductions) you should be able to
find a business related duty for just about any kind of animal. Some pets even make good models for
newsletters and advertisements. I often
see commercials for a Denver furniture store that include what I assume are the
owner’s pet lions and tigers. Parrots
and mynah birds are good at announcing visitors. It has been well documented that observing fish in an aquarium is
very effective at lowering stress levels, a necessity in any business
environment nowadays. People who have
horses should similarly have no problem in deducting those costs whether they
are used to pull things, for transportation, or if they are hired out for
occasions such as kids’ birthday parties or photo shoots. If nothing else, you could consider them as
fertilizer factories. Having shoveled
several truck loads of horse manure for our gardens, I know there is a market
for well cured droppings. Once the
animal has been classified as a deductible employee, all of the costs
associated with it are also deductible, including all special equipment and
supplies, including trailers with which to transport them. I have been preparing tax returns claiming
these things for decades. I have never
seen a need to try to hide the costs by burying them among other things. I explain exactly what they are and have
never had any of them disallowed by IRS.
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More and more
people are becoming concerned with state income taxes and taking steps to
reduce or eliminate them. Almost
weekly, I am hearing about someone moving to Florida, Nevada, Texas or
Washington, which just happen to have no income tax on individuals (along with
Alaska, South Dakota, and Wyoming).
These people are establishing bona fide residences in the tax free
states and not just pretending to as George Bush has been doing for a long
time, although a mail forwarding service works quite well until a new home is
ready for occupancy.
The taxing states
obviously don’t like this maneuver. California
loves to catch people near the border who try to source their income as from
Nevada. Just recently, Arkansas’ Dept.
Of Finance & Administration sent out notices to people who filed 1040s with
IRS showing Arkansas addresses demanding that they file Arkansas income tax
returns for those years. DFA is
assuming that the income is subject to Arkansas tax. So far, the notices I have reviewed were in error. While the filers had Arkansas mailing
addresses, all of their income for those years was earned in other states. Luckily they checked them with me because
they were ready to make the normal assumption that such notices are
correct. As with IRS notices, those
from state taxing agencies are more often wrong than they are right.
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It is well
documented that the Clintons wasted no time in putting the IRS and other
federal agencies to work attacking their critics from their very first days in
the White House. As with their other
shenanigans, they have taken Richard Nixon’s abuses to record levels. After refusing to accept the Clintons’
proposed financial settlement, which included no formal apology, Paula Jones
and her husband were notified by IRS that their tax return is being
audited. Normally, this is a private
matter between IRS and the taxpayers, but Mrs. Jones’ spokeswoman decided to
publicize it.
Since this hit the
national news, I have been flooded with queries as to whether I believe this to
be another Clinton ordered IRS audit or just sheer coincidence. I must first say that I haven’t seen the
Jones’ actual tax returns. However,
based on the information I have been told about their finances and tax returns,
as well as my intimate knowledge of exactly how IRS functions when it comes to
audits, it isn’t hard for me to know what is going on. If I were a betting person, I would
definitely say that this audit was orchestrated by one of the Clintons’ minions
who make no bones about their operating philosophy – “the ends justify the
means.” I’m sure I’ll have this
confirmed very soon by one of my many sources inside the IRS.
When describing
the IRS audit of Paula Jones, I was at first surprised to hear Rush Limbaugh
trying to defend the IRS from accusations of being used for political
reasons. He spent quite a bit of time
explaining that they are the world’s best collection agency and that they are
free from any political involvement. He
claimed that once an audit has been started, it cannot be stopped, even if
Paula Jones were to drop her case against the sexual harassing former Arkansas
governor. Rush is either very naďve or
trying to kiss the IRS’s rear end in order to avoid an audit on his own books. I think the latter is true. As much money as he earns, he is in the
category of very high IRS audit risk, even without his opposition to the
Clintons’ socialist policies. Having
personally handled several hundred IRS audits, I know that they can be, and
occasionally are, dropped at any stage in the audit process. On a few occasions, I have even been able to
get my U.S. Senator & Congressmen to exert pressure on IRS to drop an audit
in process. If they can influence the
IRS, the President and his people definitely can. For Rush’s sake, I hope his strategy works to keep the IRS away
from him.
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