Year-end personal tax strategy
Filing a personal tax return is seldom a do-it-yourself project for the owner of a closely held business. But even though you may turn the final job over to a professional, it's always wise to know what strategy you want to follow. And with tax rates moving down next year, most of your personal year-end moves are obvious: defer income to 1988 and accelerate itemized deductions in 1987. And remember, too, that long-term capital gains will be taxed the same as ordinary income in 1988, but will top out at 28% for 1987 only.
Within this strategy I've selected a few commonly overlooked items that you and your accountant might want to consider.
* Have your bonus paid in January 1988 instead of December 1987.
* If you have state income taxes, pay your January 1988 installment in 1987, and deduct it on your federal form.
* You can charge medical or dental expenses -- or charitable contributions -- to a credit card in December and list them as deductions in 1987 even though you don't pay the bills until 1988.
* If you have loss capital assets such as securities, sell the assets in 1987 and deduct up to $3,000 of the loss against ordinary income. (As a further step, you could then contribute the proceeds from the sale to your favorite charity and take the charitable deduction.)
* On the other hand, if you have an appreciated capital asset you want to sell, consider making a gift of it to your children or to other low-tax-bracket family members. They can sell the asset and realize the gain -- and pay less income tax than you on the sale. Caution: under the new tax law, your children under age 14 are taxed at your highest bracket for their unearned income in excess of $1,000.
How to avoid estimated-tax penalties
Most business owners pay an estimated tax on their nonsalary income. Under tax reform, your estimated payment, plus the taxes withheld from your salary, must equal 90% (up from 80%) of the total tax due. If you find that you've hopelessly underestimated your tax for 1987 and face a nondeductible penalty on the underpayment, fear not. Just increase your salary withholding to cover the shortfall before the end of the year. The total amount withheld will be prorated by the Internal Revenue Service over the entire year. For example, assume that your estimated taxes are underpaid by $4,000. Have the $4,000 withheld from your salary before December 31, 1987. Then $1,000 (one-fourth of the amount withheld) will be credited against your estimated tax liability for each quarter. If instead you simply added the $4,000 to your last quarter's estimated tax payment (due January 15, 1988), you would face penalties for the first three quarters.
If you're like most company owners, there's at least one favorite charity that counts on a nice check from you every December. But a quirk in the law allows you to use a little-known tax break to help that charity and yourself beyond the usual deduction. The increase in value of your company's stock, together with the new law's elimination of a special tax rate on long-term capital gains, are the basis of the opportunity.
This is the rule: you can deduct the fair market value of any property contributed to a charity as long as the property, if sold, would produce a long-term capital gain. And any gain that would have been realized on the sale escapes tax.
Here's an example of how this can work. Let's say that when you started your business the stock cost you 10? a share. Today it's worth $100 a share, virtually all capital gain. If you donate 100 shares -- worth $10,000 -- to your favorite cause, the capital-gains tax to you is zero, compared with the top 1987 rate of 28% if you sold the stock. And you can take a $10,000 charitable deduction, which could save you $3,850 if you're in the top 1987 tax bracket.
Since stock in a privately held company is likely to be of little use to the charity, however, arrange to have your company buy the stock back at its full value. The charity gets $10,000, you get the gift deduction, and you have, in effect, cashed out $10,000 from your company dividend free. And you still own 100% of the corporation's stock.
Before you take the ball and run with this one, a word of caution. The transaction is complicated and should be carefully worked out with your tax adviser. You lose the deduction, for instance, if the charity is obliged to sell the stock back to your company -- it must have the right to keep the stock if it chooses, though it's OK to prohibit sales to anyone else. If the stock is worth more than $5,000, the IRS will require that it be independently appraised. And check the effect of the alternative minimum tax on the tax-free capital-gain portion of your contribution.
The dangers of the year-end bonus game
To come up with their own bonuses, company owners often wait until close to year end, estimate their profit picture, and then decide on the amount. That practice can cost your company, however, since the IRS may well look on the bonus as a nondeductible dividend rather than as compensation. Avoid the problem in the future by documenting in the corporate minutes early in the year the amount of your annual compensation and the services you will render to earn it. Set the compensation high, but take a smaller weekly salary. Say you take $1,000 a week after setting a $100,000 salary for the year. If you have a good year, great -- take the $48,000 balance as a bonus. If not, then waive all or a portion of the $48,000. (If you have an S corporation, the bonus question is moot since all corporate profits are taxable to you anyway.)
SUMMARY OF PERSONAL TAX RATES
TAX JOINT SINGLE
RATE RETURNS INDIVIDUALS
11.0% Up to $3,000 Up to $1,800
15.0 3,000-28,000 1,800-16,800
28.0 28,000-45,000 16,800-27,000
35.0 45,000-90,000 27,000-54,000
38.5 More than 90,000 More than 54,000
15.0% Up to $29,750 Up to $17,850
28.0 29,750-71,900 17,850-43,150
33.0 71,900-149,250 43,150-89,560
28.0 More than 149,250 More than 89,560