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MONTHLY TAX NEWSLETTER

"KIDDIE TAX" INCREASED FOR SECOND TIME IN TWO YEARS

by Andrew D. Schwartz, CPA

For the second time in just two years, the Kiddie Tax, introduced as part of the massive Tax Reform Act of 1986, was made even broader. Prior to 2006, any unearned income above a certain threshold earned by a child under the age of 14 was taxed at the parent's tax rate.

In 2006, the Tax Increase Prevention and Reconciliation Act of 2006 expanded the Kiddie Tax to include children 17 or younger who earn more than $1,700 (in 2007) in interest, dividends, capital gains, and other non-wage income. 

This year, as part of the Small Business and Work Opportunity Tax Act signed into law on May 25^th, the Kiddie Tax was bumped up to age 18, and up to age 23 for children who are full time students, except for these children whose earned income exceeds more than half of that year’s support, effective 2008.

New Rules

Understanding how your child will be taxed is very important when determining how to best save money for their college education.  Unfortunately, parents who managed to build up a college savings nest egg in their children's names can expect to be hit with higher tax bills when liquidating those investment to pay for college.

Here's how the Kiddie Tax will work starting in 2008.  The first $850 (based on the 2007 brackets) of net investment income earned by a child isn't taxed, and the next $850 is taxed at a rate of either 5% or 10%, depending on the type of income earned. Any additional income is taxed based on the child's age as follows:

• Children 17 or younger:  A child's net investment income earned during the year that exceeds the $1,700 threshold (in 2007) is taxed at the parent's marginal tax rate.

• Child age 18:  Unless your child's earned income exceeds half of his or her support for the year, the child is subject to the Kiddie Tax.

• Children between the age of 19 and 23: If a child is a full-time student whose earned income does not exceed more than half of their support, a child is taxed under the Kiddie Tax rules. 

• Children over the age of 24: Upon reaching the age of 24, a child's income is taxed using the same tables that apply to single adults. For 2007, the first $7,825 of net taxable income is taxed at 10%, and then the next $24,025 is taxed at 15%. As with all taxpayers, corporate dividends and long-term capital gains are taxed at just 5% for income falling within the lowest two brackets, which equals $31,850 in 2007.

Saving For College Under the New Rules

Now that the Kiddie Tax applies to children through age 23, it makes even more sense for parents to consider saving for a child's college education either in their own name or within a 529 Plan or Coverdell Education Savings Account (ESA).  Don't forget that the Pension Protection Act of 2006 made tax-free distributions from 529 plans permanent.

• For financial aid purposes, effective July 1, 2007, 20% of the money held within your child's name is generally considered available to pay tuition and other related expenses, while a maximum of 5.6% of money held in the parent's name, including 529 plans, counts - according to FinAid.org.

• If your child receives a full scholarship or decides not to go to college, any money saved in that child's name becomes his or her property upon reaching the applicable age of majority in their home state.

The Six Month Solution

Nothing ruins good financial planning as quickly as a change to the income tax code.  So what steps should you take in light of these new rules?

If your child is young, take a long look at 529 plans.  The government really designed a great way to save for your child's education.  And it's tough to beat the fact that 529 plans provide you with tax-free growth.

What if your children are older, and you have already saved a bunch of money in their names earmarked for their college education?  Since the new Kiddie Tax rules don't take effect until tax years starting after May 25, 2007, you have the next six months, until December 31, 2007, to minimize  your family's tax bite. 

Consider selling enough of your child's investments to take advantage of the reduced tax rates available this year only to children who are 18 or older by December 31st.  For 2007, the tax rate on the first $31,850 of long-term capital gains is just 5%, provided your child has no other income. 

Then, determine if it makes sense to take the money and open a UGMA 529 plan.  Since these plans are considered your child's money, they are significantly less flexible than the standard 529 plan.  Even so, this strategy will allow your child's college money to grow tax-free from this point forward.

Reversal of Fortune For College Savings

How people save for a child's college education has changed dramatically over the past few decades.  Prior to the introduction of the Kiddie Tax twenty years ago, saving for college in a child's name was very common.

These days, with the broader Kiddie Tax rules, the increased popularity of 529 Plans, and the current financial aid formulas, the trend is now for parents to build up a college savings nest egg in their own names.

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UNDERSTANDING THE "HOBBY LOSS" RULES

by Andrew D. Schwartz, CPA

In today's tax code, not all losses are created equally.  Whenever you're engaged in a part-time business, it's important to understand the "hobby loss" rules.

Get this.  If you make money from a hobby, expect to pay income taxes on those profits.  Even so, if you show a loss, you're generally not allowed to claim that loss on your tax return. 

Three Out Of Five Years

How can you tell if an activity is a hobby or has a profit motive?  The litmus test is pretty simple.  If your activity is profitable for three or more years during the five year period ending with the current tax year, then the activity is NOT a hobby.

Nine Factors To Distinguish A Hobby Versus Profit Motive

Like most provisions in the tax code, there are exceptions to the three-out-of-five-year hobby loss test.  The IRS regulations include the following nine factors to help you determine whether an activity has a profit motive or should be classified as a hobby.

1. Manner in which you conduct your activity:  To show a profit motive, you're required to run the activity in a businesslike manner, maintain a set of books for the activity, and actively promote your activity.

2. Expertise of you and your advisors:  If you are not an expert in a field and don't consult with other experts in that field, the activity will appear to be a hobby.

3. Time and effort expended in conducting the activity:  The more time you put in, the better your chances of having the activity not classified as a hobby.

4. Expectation that the assets used in the activity may appreciate in value:  Even if you have losses each year, if you expect the business assets to appreciate quicker than the losses accumulate, the activity won't be considered a hobby.

5. Success in conducting other similar or dissimilar activities:   If you have a track record of running similar activities that were profitable, it's easier to prove that you expect this activity to be profitable as well.

6. Your history of income or losses with this activity:  A track record of losses each year over a number of years makes it tough to prove that you have a true profit motive.

7. Amount of occasional profits from the activity:  Small profits and substantial losses tend to describe a hobby.

8. Your financial status:  The larger the activity's loss as compared with your net worth, the more likely you can prove that there is a profit motive.

9. Personal pleasure or recreation:  The more enjoyable the activity is to you, the more likely the activity is your hobby.

Pitfalls of a Hobby

How costly is it to you if an activity is classified as a hobby?  For starters, you're not allowed to claim your hobby losses on your tax return.  So even if you truly lose money from the activity, you don't get any tax break.

Plus, unlike most other types of losses, you aren't allowed to carry your hobby losses forward to subsequent years to offset future profits from this activity.

When you're engaged in a hobby, the way you claim your allowable expenses creates a variety of tax headaches. 

Instead of reporting your hobby income and the allowable expenses on the same form such as a Schedule C, you're required to report your hobby income as "Other Income" on Line 21 of your 1040. You then include the offsetting expenses with your other Miscellaneous Itemized Deductions such as investment fees, tax prep fees, and unreimbursed employee business expenses on the Schedule A. 

Here's the problem with Miscellaneous Itemized Deductions.  First off, they are only deductible to the extent they exceed 2% of your adjusted gross income and then, will only benefit you if you're able to itemize your deductions.  To make matters worse, miscellaneous itemized deductions are excluded when calculating the Alternative Minimum Tax.  So chances are that one way or another,  you'll lose out on the bulk of your hobby expenses.

The way you report your hobby income and expenses on your tax return causes additional tax problems as well.  Since you're reporting the activity's gross income as Other Income, you end up increasing your Adjusted Gross Income, increasing the chances of your losing out on a variety of tax breaks including personal exemptions, child tax credit, education credits, student loan interest deduction, and Roth IRA eligibility.

No Self-Employment Tax

There is a silver lining for people who are profiting from their hobby.  Unlike most other self-employed ventures, income from this activity is not subject to self-employment taxes. 

Delay a Decision

Not sure if you should treat an activity as a hobby or business?  Believe it or not, the IRS has a tax form for this.  You're allowed to postpone determination whether an activity should be considered a hobby by filing a Form 5213. 

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TAX AND FINANCIAL PLANNING CALENDAR FOR JULY, 2007

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2006 & 2007 TAX FACTS

• For 2006, the standard deduction for a single individual is $5,150 and for a married couple is $10,300. A person will benefit by itemizing once allowable deductions exceed the applicable standard deduction. Itemized deductions include state and local income taxes (or sales taxes), real estate taxes, mortgage interest, charitable contributions, and unreimbursed employee business expenses.
• For 2006, the personal exemption is $3,300. Individuals will claim a personal deduction for themselves, their spouse, and their dependents. 
  
• The maximum earnings subject to social security taxes is $97,500 for 2007, up from  $94,200 in 2006.
  
• The standard mileage rate is $.485 per business mile for 2007, up from $.445 per mile in 2006.
  
• The maximum annual contribution into a 401(k) plan or a 403(b) plan is $15,500 in 2007.  And if you'll be 50 or older by December 31, 2007, you can contribute an extra $5,000 into your 401(k) or 403(b) account this year.
• The maximum annual contribution to your IRA is $4,000 for 2007.  And if you turn 50 by December 31st, you can contribute an extra $1,000 that year.  You have until April 15, 2008 to make your 2007 IRA contributions. 

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