From the December 2004 issue of Investment Advisor • Subscribe!

Before the Year Runs Out . . .

The dreaded AMT and other terrors

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With only a month left in this tax year, there are a few things advisors should know when it comes to tax planning. Dealing with the Alternative Minimum Tax [AMT] and making the most of retirement contributions should be at the top of your list.

Surprisingly however, there is one issue that, for at least the next 12 months, is likely to demand little or no discussion with your clients: new tax legislation.

We recently spoke with Maureen McGetrick, senior tax manager with Chicago's BDO Seidman, LLP, a national middle market accounting firm that serves both businesses and high-net-worth individuals, about year-end tax planning and what not to expect in 2005.

What are the most important year-end tax steps that advisors should recommend to their clients, especially their higher-net-worth ones? We advise our clients to do a projection for the year to determine, in the high-net-worth arena particularly, where their tax liability is going to be in the AMT. This is something that we are finding a growing number of people trapped in. If a client does fall under the AMT, although there is not a lot you can do to prevent it, there might be some things you can do to minimize its effects.

It might be in the best interest of the client to push some deductions into the following year. Additionally, you wouldn't want to prepay income taxes, which some advisors might normally advise their high-net-worth clients to do in December. If your clients are in AMT, clearly you don't want to do that because the deductions will have no benefit for them.

To alleviate some of the strain caused by AMT, you might suggest pushing off business-related expenses to the following year as well, even though these items are not deductible for AMT purposes. Real estate tax is another item you may have to play with that wouldn't be deductible for AMT.

At year end, individuals will also want to look at maximizing retirement plan contributions. Review the [investment] portfolio and look for any gains that should be realized prior to year end. Find out if there are any losses that have already been realized that will offset the gains, or if there is a capital loss carryforward from the prior year that will offset the gains.

Many advisors complain that the AMT is a monster that's unfairly devouring U.S. taxpayers. What steps should advisors recommend to limit AMT exposure? Do you expect the new Congress to pass, and President Bush to sign, any tax legislation that would address the issue, perhaps extending the increased AMT exemption amounts, and indexing them for inflation? All of that is true. The AMT is gobbling up more and more taxpayers, particularly with the reduced rates on capital gains and dividends. Although those rates apply for purposes of AMT, as an individual's effective rate lowers as a result of deductions, the AMT will kick in. If you have a taxpayer that is in AMT, then look at the timing of your client's deductions and whether or not there are items that can be pushed off into the following year when perhaps they will not be in AMT.

Incentive stock options are an AMT adjustment item. For individuals in that situation, plan timing of those exercises to minimize the impact.

In terms of legislation to deal with AMT, what has been passed so far has really been very minimal. They have only increased the exemption amounts by a small fraction. So if you are dealing with a high-net-worth individual, that has very little impact.

Any changes that have been made were intended to remedy the effects on middle-income taxpayers. Everyone at the IRS and the Treasury Department has acknowledged that it's a problem. But how do they replace that revenue? I don't think legislation has addressed that issue.

What is the most common mistake that wealthy folks and their advisors make with regard to taxes? What do they fail to consider that could not only lower their clients' taxes in a given year, but also position themselves to keep more of their hard-earned money over time? I don't know that I would say this is a common mistake, but something that would position people to keep more of their money is looking at their investments and how their investments are being taxed. Find out if your clients are really maximizing their after-tax rate of return. The recent change in dividend rates has allowed for more flexibility [in that area].

Another thing for high-net-worth individuals is determining charitable contribution deductions. Should they be making solely cash contributions? Could they make some property contributions--say of appreciated stock--to make those contributions work more efficiently for them?

How would you recommend that advisors stay current on tax code changes, legislation, and IRS rulings, especially for those who aren't CPAs but yet must be knowledgeable enough to spot tax issues for their clients before it's too late? A good way to stay current is constant communication with a tax advisor and working with your clients' accountants to determine if there is something you should be looking at at year end.

Find out if there were issues with last year's tax return, if there is a deduction they wouldn't get a benefit from, and if there are any issues of capital loss carryforwards.

[To stay current], you can attend specialized seminars relating to tax planning for high-net-worth individuals. There are several firms out there that give those types of seminars.

Usually, you'll learn about any income tax implications and estate- and gift-tax implications, all of which are extremely important in the high-net-worth arena.

What are the red flags that IRS auditors look for, and that advisors should recommend their clients avoid? It is difficult to say if there are any particular red flags for audits. The IRS will look at amounts from one year to the next. For instance, if your charitable contributions increase drastically or your state and local income taxes increase drastically [the IRS] would look at [those items]. If you have a huge operating loss, perhaps a large property contribution, or an appraisal, they may look at those as well.

One particular thing we have commonly found that is a heavy target for auditing by the IRS is if somebody has a self-employed business and they are reporting their sole proprietorship on a Schedule C. That's because the IRS seems to feel that people are more likely to push through personal expenses on a Schedule C. I don't know why they think that is more true than with an S corporation, but that seems to be their approach.

Always advise your clients to keep excellent records--that will make the auditing process a lot easier.

I don't think that the IRS is looking to unfairly punish taxpayers; they just want to make sure that people are compliant with the law.

Some investors sat on the sidelines during the Presidential campaign. For example, some experts advised clients to take advantage of the lower capital gains rates and the more favorable dividend tax rates introduced by President Bush's two major tax cut bills--EGTRRA in 2000, and JGTRRA in 2003--just in case John Kerry was elected and then moved to repeal some of those changes. Would you have recommended those steps? Now that President Bush has been reelected, would you change your recommendations to clients? That is true--many people were hesitating to see what would happen with the election. I think clients need to continue to review their investments.

With the lower tax rate on dividends, you can get a pretty tax-efficient return on your investment in some high-yielding stocks. People may want to continue to look at that option as opposed to a tax-exempt bond.

In terms of capital gains, some investors may have been considering generating capital gains at year end depending on their situation. If you have generated a gain already there is nothing you can do about it, but looking at your portfolio at year end there could be a sigh of relief to some extent.

How would you recommend clients deal with the sunset provision on the repealed "death tax," and how this uncertainty affects their estate planning? Everybody is aware that it's out there and I think clients need to be aware of it, but you can't really plan too far ahead. Clients should speak to their attorneys and review their estate and gift plans in light of the increased exemption amounts. But people need to plan with the law as it exists and just review any updates with respect to the sunset position as they come up each year.

Are there any tax code changes you expect to take place over the next year or so, either because the President has promised such action, or as a consequence of previous legislation or IRS promises? I don't think we are going to see anything significant within the next 12 months because a pretty extensive tax bill was recently passed (JGTRRA in 2003] and most of the provisions pertain to business.

However, the next issues in terms of future tax reform are going to be with the AMT and probably the estate tax. Those seem to be hot issues for the President. [Other things] some people have thrown around are possible further changes to the dividend tax rates, but I am not sure that I would anticipate anything really significant within the next 10 to 12 months.

Any other thoughts advisors should keep in mind? Continue to remind clients about the estate- and gift-tax provisions.

Freelance business journalist Megan L. Fowler writes from her home in Fairbanks, Alaska. She can be reached at mlfr@magwriter.com

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