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Expecting Capital Losses? Use Them to Shelter Capital Gains.

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The rules on deducting capital losses are pretty strict. You can deduct capital losses against capital gains. Capital losses can also be deducted against $3,000 of your ordinary income per year. So if you have only ordinary income, no capital gains, and a $30,000 capital loss, it would take you 10 years to fully deduct the capital loss.

If you have such large capital losses, you should review your stocks to see if any have appreciated in value. You can then sell the appreciated stock and generate capital gains. These capital gains will be sheltered by the capital losses. You can then repurchase the stock and obtain a a higher tax basis that reflects its current price.

Our Friend, the Laffer Curve

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The above graph is the Laffer Curve, named after economist Arthur Laffer. This graph demonstrates that when tax rates are increased past a certain rate, tax revenues will decline.

The important aspects of the Laffer Curve are:

  • At a 0% tax rate, tax revenues are $0
  • At a 100% tax rate, tax revenues are also $0
    • No one works when the government takes 100% of his/her earnings
    • Businesses will close operations and move offshore
      • “Taxes don’t redistribute income, they redistribute people”–George Gilder
    • People may work enough for basic sustenance, but they will likely report no income to the IRS
  • The revenue maximizing rate is represented by the green dot at the peak of the curve
    • The exact revenue maximizing rate is subject to strong debate
  • When the tax rate rises above the maximum point, tax revenues will decrease
    • By having more and more of their money taken away from them, people will become discouraged and will not work as long or as productively
  • The horizontal line running through the two blue dots shows that an equal amount of revenue can be raised at two different tax rates–a low rate and a high rate
    • Between the high rate and the low rate, Congress should set taxes at the low rate because the higher rate will constrain economic growth

Arthur Laffer and Stephen Moore (from the Wall Street Journal) have a new book called “The End of Prosperity–How Higher Taxes Will Doom the Economy, If We Let it Happen.” It is an excellent read and explains how lower taxes and other supply side principles fuel economic growth. It is available through the Recommended Books link above.

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What is Tax Fairness?

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Tax reform is almost always a topic during presidential elections. This post will discuss some concepts and ideals of tax fairness. The following principles are usually debated in discussing fair tax policy:

  • Simplicity
    • the tax rules should be simple
  • Transparency
    • the amount of tax paid should be visible to taxpayers
    • for example, when you buy a $20,000 car, the $1,200 of sales tax is visible to the buyer on the car invoice
  • Stability
    • the tax laws shouldn’t constantly change
    • constantly changing tax laws increase complexity and reduce predictability
  • Growth Promotion
    • taxes should raise revenue for necessary government expenses and should consume as small a portion as possible of national income (GDP)
  • Neutrality
    • taxpayers with equal amounts of income should pay equal amounts of tax–tax policy should not subsidize/penalize different types of income and deductions

The Candidates’ Tax Proposals

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For those who are interested in learning more about Senators Obama’s and McCain’s tax proposals, there are a couple of tax think tanks that have published studies of the impacts of both plans. The Tax Policy Center (which is slightly left leaning), is a joint venture of the Urban Institute and Brookings Institution released an updated study on September 12 on the tax plans. The Tax Foundation, which is a slightly right-leaning think tank, also released a study on September 19. The Tax Foundation also explains how both candidates misstated tax facts during the first two debates.

Recordkeeping Requirements

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The IRS usually has 3 years to audit a tax return. However, if there is a 25% or greater understatement of income, the IRS has up to 6 years to audit. If the taxpayer has committed fraud, the IRS can go as far back as it wants. The IRS has a policy of NOT going back more than 6 years, but this is just policy–it can be changed at any time.

To ensure that you have support for your income and deductions, you should generally keep records for 7 years (the maximum six years the IRS can go back, plus 1 year for good measure).

If you don’t keep adequate records, the IRS can reconstruct your income using various methods including:

  1. The Net Worth Method: The IRS determines your net worth at the beginning of the tax year and at the end of the tax year. The difference is income. The IRS then adds nondeductible expenses, payments of federal income tax, and gifts paid to others. The IRS will then tax you on this sum.
  2. The Expenditures Method: The IRS looks at your expenses for the year and compares them to your income. If the expenses exceed income, the IRS assumes the excess is income and applies a tax.
  3. The Deposits Method: The IRS assumes that your bank deposits are income and applies a tax unless you can prove that the source of the deposits was tax-exempt.

So, what type of records should you keep and for how long?

These items should be kept for 7 years:

  • cancelled checks
  • credit card receipts
  • paid invoices
  • bank deposit slips
  • bank statements
  • tax returns (uncomplicated)
  • employment tax returns
  • expense records
  • inventory records

The following items should be kept for the life of the asset (or business) plus 7 years:

  • corporate minutes
  • depreciation schedules
  • real estate records
  • general ledgers
  • home purchase & improvement records
  • investment records

The following items should be kept permanently:

  • complicated tax returns
  • contracts
  • corporate stock records

Income Too High for a Roth IRA?

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Roth IRAs are tax advantaged retirement saving accounts. Contributions to Roth IRA accounts are NOT deductible. However, any earnings on the contributions can be withdrawn TAX FREE once the taxpayer reaches age 59 1/2 and it has been at least 5 years since the first year of Roth IRA contributions.

Example: Beginning in 2000, Joe makes an annual Roth IRA contribution of $2,000. As of 2008, he has contributed $16,000 and the account has earned $3,000 in interest. If Joe is over age 59 1/2 he can withdraw the entire $16,000 in contributions and $3,000 of interest tax free since it has been more than 5 years since he made his initial Roth IRA contribution.

Roth IRA contributions are disallowed when a joint filer has $169,000 in modified adjusted gross income (MAGI) and a single filer has $116,000 of MAGI.

The Strategy
Beginning in 2010, there will no longer be an income phaseout for Roth IRAs. In the meantime it can be beneficial to make traditional IRA contributions during 2008 and 2009, and then convert these contributions to a Roth IRA in 2010.

Example: Joe’s income is too high for him to make a Roth IRA contribution. He can wait until 2010 to make a Roth IRA contribution. If he doesn’t want to wait, he can make $5,000 traditional IRA contributions in 2008 and 2009, and then convert the $10,000 traditional IRA account (plus earnings) into a Roth IRA in 2010. Additionally, Joe can make a $5,000 Roth IRA contribution in 2010.

The point of this strategy is to get as much money as possible into a Roth IRA by 2010. I’ve gone over the basics of the strategy, but it is very important to talk to a tax professional before implementing the strategy to make sure it is done correctly.

Avoiding the 10% Penalty on Early IRA Distributions

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There are times when an IRA owner has to take an early distribution. Normally, distributions taken before age 59 1/2 will be subject to a 10% penalty. For example, if you take a $10,000 distribution, an early distribution penalty of $1,000 could apply. There are exemptions from this penalty. The exempted distributions are:

  • made on or after the taxpayer’s death
  • attributable to the taxpayer becoming disabled
  • part of a series of substantially equal payments (annuity) for the life of the taxpayer or the joint lives of the taxpayer and a designed beneficiary
  • used to pay medical expenses to the extent the distribution does not exceed the employee’s deductible medical expenses
  • used to pay deductible medical insurance if the individual has received unemployment compensation under federal or state law for at least 12 consecutive weeks in the year of withdrawal or the previous year
  • used for first-time homebuyers (subject to a $10,000 lifetime cap)
  • used to fund higher education expenses
  • made on account of an IRS levy on an IRA
  • made to a qualified reservist
  • qualified distributions to victims of Hurricane Katrina, Rita, or Williams
  • made incident to divorce

If your distribution falls within one of these exemptions, your distribution will not be subject to the 10% penalty. However, the distribution will still be subject to income tax.

Rules for Charitable Deductions & Some Other News

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Make Sure Your Charitable Contributions Are Deductible
The IRS has increased the record keeping requirements for cash charitable deductions under $250. Under prior law, cash donations of under $250 could be documented by a simple record maintained by the taxpayer. For example, if you donated $10 per week ($520 per year) at church, you could document the donations by simply keeping a record log. Under current law, for donations under $250, you must now maintain a bank record (such as a canceled check) or a detailed written receipt from the charity. Under current law, if you donated the same $10 per week in cash you could NOT claim a deduction unless the church gave you a written acknowledgment of how much you contributed during the year. If you donated a $10 check every week, you could claim the deduction based on your canceled checks.

The rules for cash gifts of $250 or more have not changed. These donations require a written acknowledgment from the charity. Bank records will not suffice for cash donations over $250.

Big Business May Take Big Tax Hit
The IRS has proposed to FedEx the reclassification of its delivery drivers as employees, rather than as independent contractors. If the IRS succeeds in the reclassification, FedEx will owe tax and penalty of $319 million plus interest for misclassifying the drivers.

Save Money Under the Economic Stimulus Act of 2008

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Here are a couple of tax-saving provisions of the new Economic Stimulus Act that haven’t gotten as much attention as the stimulus rebate checks about to be sent out.

Increased Section 179 Deduction
Section 179 allows first year expensing of certain depreciable property. Quick example–if you purchase a piece of machinery for $20,000, you could normally depreciate the property over five years, taking a $4,000 deduction each year. Under the new Section 179 limits, in 2008 you can deduct up to $250,000 ($125,000 in 2007) per year of qualifying property. Instead of deducting that $20,000 piece of machinery over five years, you could deduct the entire purchase price ($20,000) in 2008. For 2009-2010, the maximum deduction will revert back to $125,000. One of the limits of Section 179 is that it is limited to the taxable income of your business. For example, if your taxable income is $10,000. Your Section 179 deduction in the above example would only be $10,000. The remaining $10,000 of Section 179 deduction would be carried forward into future years.

Bonus 50% Depreciation
Under this rule, your business can immediately write off 50% of the cost of qualifying assets in the first year. The remaining cost can be deducted either through Section 179 or through regular depreciation deductions. Unlike Section 179, there is no taxable income limitation. For example, if you purchase a $30,000 piece of equipment and your taxable income is $5,000. You could claim bonus depreciation of $15,000–taking your taxable income down to a $10,000 loss. You could then claim regular depreciation on the remaining purchase price.

IRS Issues Warning Regarding Stimulus Rebate Check Scams
The IRS has issued warnings regarding e-mail and phone scams regarding the Economic Stimulus Act rebate checks. To view the warning, click on,,id=178061,00.html

Opening Post

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Welcome and thank you for checking out my blog. As I develop this blog, I’ll be organizing the blog into six sections:
1. Tax tip of the week
2. Tax scam of the week (this will include disreputable tax strategies and other scams such as phishing emails supposedly sent by the IRS)
3. My own free-market-capitalist opinion on upcoming changes in the tax laws and in other business legislation.
4. For those of you who can’t get enough celebrity gossip, I’ll be posting news on the tax troubles of celebrities and big business.
5. Business book reviews
6. Recipes for tasty chicken dishes (or not)

I’ll keep the postings as short and to the point as possible. I spend several hours a week reading up on tax and business news and I’ll try to distill that info into a few paragraphs.

Stay tuned…

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