HIGHLIGHTS OF 2006 TAX LAW CHANGES Congress recently passed two major and one minor tax bills. The Pension Protection Act of 2006, signed into law on August 17th, provides the most significant pension changes in decades.  It is a whopper- one of the largest bills (900-plus pages) to come out of the 109th Congress.  But the Pension Act is not only about strengthening pension plans; it affects a much broader population.  This new law helps virtually everyone save more for retirement by adding new and enhanced retirement-savings incentives and making many higher contribution and benefit levels permanent.  This new law changes a host of rules on charitable giving, IRAs and 401(k)s.  Some of the changes affecting IRAs and 401(k)s are effective immediately; others are retroactive, and there are some that kick in next year or even later. Earlier this year on May 17, the President signed the Tax Increase Prevention and Reconciliation Act (TIPRA).  This major tax bill impacts a broad cross section of taxpayers.  The new law contains $70 billion in net tax cuts, gives taxpayers some immediate relief from the alternative minimum tax (AMT), extends some business expensing thresholds, tightens up the wage limits on Sec. 199 domestic production activity deduction (DPAD), and makes many other significant changes. A lesser-known tax bill, the Heroes Earned Retirement Opportunities (HERO) Act, was signed into law on May 29.  It allows members of the armed forces serving in combat-designated localities to count tax-free, combat pay as earned income in determining the contribution amount to a traditional or Roth IRA beginning in 2004.

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CHANGES FOR INDIVIDUALS AMT Relief If you're one of the many taxpayers who is subject to the alternative minimum tax (AMT), you will be pleased to know that the new law increases the exemption amounts for tax years beginning in 2006.  The increased exemption amounts for the 2006 tax year are: $62,550 for married individuals filing a joint return and surviving spouses; $42,500 for unmarried individuals; and $31,275 for married individuals filing separate returns. The new law gives the growing number of individuals otherwise subject to AMT only a one-year reprieve.  Unless the increased exemption amount is further extended, the AMT exemption amounts for individuals are scheduled to revert for tax years beginning after 2006 to the amounts that applied prior to the 2001 tax year.  Thus, the exemption amounts would go back: (1) $45,000 for married individuals filing a joint return and surviving spouses; (2) $33,750 for unmarried individuals; and (3) $22,500 for married individuals filing separate returns. Increased Age Limit for Kiddie Tax The age of minor children whose investment income is subject to tax at their parent's higher rate is increased from under age 14 to under age 18.  This means that unearned investment income above $1,700 (for 2006) of a child under age 18 is exposed to taxation at the parent's marginal income tax rate.  However, distributions for qualified disability trusts are treated as earned income of the child; therefore, the distributions are exempt from the kiddie tax.  Planning Tip:  The age increase is effective retroactively to the start of 2006, making its impact immediate and of concern for many college savings accounts that have been in a child's name.  For example, if you had planned to sell a portion of your child's college stock portfolio in 2006 when she reaches 14, you will now have to wait four more years if you intend to take advantage of the child's lower tax rate.  Parents who had planned to postpone a sale until 2008 when the capital gains rate would be zero for their child now must make sure that the child reaches 18 by then; otherwise, the gain will still be taxed at the parent's presumably higher rate.  Perhaps most unfair, but nevertheless still the law, is the new law's retroactive impact on parents who sold investments of their 14 year old child during the first few months of 2006, before the "kiddie tax" law was changed.  That income is taxed at the parent's higher rate anyway, with no chance for the parent to undo the sale. Charitable Contributions The new law makes important changes to the rules for charitable donations that affect almost everyone claiming a charitable deduction.  Most of the changes tighten the rules, but Congress has added a handful of favorable tax breaks tempered by a short window of opportunity. Clothing and Household Items Any donations of clothing and household items that you make to charity starting January 1, 2007, will not be deductible unless the donated items are in "good" or better condition.  This means that the IRS may deny a deduction for any item that has minimal monetary value.  It also means that you need to be prepared to prove both the condition and the value of your donation; do not expect the charity to maintain the records once your items have been picked up. One exception:  If the donation of a single item that is donated is not in at least good condition but it nevertheless is worth more than $500, it is deductible as long as you also get a qualified appraisal at the time of the donation. Cash Donations You may no longer deduct contributions made in cash or by check or other monetary gifts unless you can produce a bank record or a receipt, letter, or other written communication from the charitable organization.  This strict requirement applies regardless of the amount of the donation.  The written proof must be provided at the time of the donation and must include: the name of the charitable organization, the date of the contribution was made, and the amount of the contribution. This substantiation requirement is effective for contributions made in tax years beginning after August 17, 2006.  For most calendar year taxpayers, that's starting January 1, 2007. The new record keeping requirement no longer will allow courts or IRS examiners to take a taxpayer's word on small donations.  You must have written proof for a deduction, even if it is only $1 thrown into the Salvation Army holiday kettle.  Donations above $250 continue to require the addition of a statement by the charity as to whether something of value was received in return for the donation. Tax-free IRA Distributions to Charities Owners of IRAs who are 70½ or older can give as much as $100,000 from their IRA or Roth IRA to charitable organizations in 2006 and again in 2007 without recognizing any income on the distribution.  This means that the distribution will not be included in gross income-usually a better deal than taking an itemized deduction for it.  The distribution must be done as a direct rollover from the IRA trustee to the charity. Planning Tip:  This change is helpful if you do not need to take distributions from your IRA and would prefer to avoid tax on the minimum required distributions that must be made with respect to a traditional IRA after the owner reaches age 70½.  Obviously, this tax break should be used only by those well off who have plenty of other available assets.  It is a limited time offer, so if your required minimum distribution in 2006 and 2007 is less than $100,000 you may want to top off the distribution to take full advantage of the $200,000 maximum donation over the course of the two tax years. Donor Advised Funds (DAFs) The tax deductibility of contributions to donor advised funds (DAFs) is now limited.  Donor advised funds have been touted as an ideal way to give away investments to charity yet retain control of how those investments are managed.  Again, abuse crept into this technique in connection with particular groups and so-called supporting organizations as donors received indirect benefits from investments being made in certain assets. Real Property Easement Contributions The tax law encourages the charitable contributions of property easements as a way to help preserve the natural beauty and historical heritage of our Nation.  The new law takes existing incentives in two directions:  It broadens opportunities for contributing conservation easements; and  It restricts abuses in the use of facade easements. Conservation Easements The new law is increasing the size of a conservation easement that can be deducted in any one year.  Normally, charitable deductions of "capital gain" property cannot exceed 30 percent of your adjusted gross income each year.  While excess deductions can be carried over into future years, they are not as valuable.  The new law changes that in two ways: All individual donors are allowed to take charitable deductions of up to 50 percent of their contribution base for contributions of qualified conservation real property (this can involve vacation property, land held for investment, business property, or even your primary residence). For farmers and ranchers, the contribution base is raised to 100 percent of the contribution base (with corporate donors that qualify as farmers or ranchers also able to claim a conservation charitable deduction of up to 100 percent of taxable income, subject to special rules for determining taxable income for this purpose). Facade Easements Facade easements, usually based on a deeded promise to preserve the front face of a building in keeping with its historic past, have been the subject of some aggressive tax planning recently.  Such planning generally involved valuing the easement too high. Stricter rules apply to the charitable deduction for contributing a facade easement for a building in a registered historic district.  Deductions are disallowed completely for personal residences, unless the residence is listed individually in the National Register of Historic Places.  Whatever deduction is allowed must be reduced to take account of the rehabilitation credit.
IRA CHANGES Permanent Roth 401(k)s The new law makes the Roth 401(k) plan optional (and its public-sector 403(b) plan equivalent) permanent.  This will open up the floodgates that will make the "Roth option" common in most plans. Under the option, employee contributions may be allocated as Roth contributions.  As such, they will not be considered pre-tax contributions.  But unlike regular 401(k) and 403(b)s, eventual distributions during retirement will be completely tax free, which for most retirees, more than makes up for the loss of the pre-tax benefit. Although EGTRRA provided for the Roth 401(k) option, it did not make it effective until 2006 and, under its provisions, they ended in 2010.  Most employers did not want to add the Roth option to their 401(k) plans because of the lifetime administrative costs associated with maintaining separate accounts for a benefit that was to end in just a few years.  Now that the Roth option is permanent, it suddenly becomes a cost-effective benefit. Roth IRA Conversions and Rollovers You will soon have much greater flexibility when it comes to Roth IRA conversions.  Although Roth IRAs have existed for a number of years, restrictions on rollovers have kept them from gaining the popularity that was originally expected.  One of the major impediments to conversion from a traditional IRA to a Roth IRA is a limitation based on adjustment gross income (AGI) of $100,000.  Additionally, current law does not permit taxpayers to make rollover contributions directly from other qualified plans to a Roth IRA. Beginning in 2008, distributions from a tax-qualified retirement plan, tax sheltered annuity or governmental plan can be rolled over directly into a Roth IRA.  However, until 2010, rollovers to a Roth IRA will only be allowed if the taxpayer's AGI does not exceed $100,000. Higher-income individuals will soon have the opportunity to convert to a Roth IRA also.  Beginning in 2010, the $100,000 AGI limitation for rollovers to a Roth IRA-whether from a qualified plan distribution or from a traditional IRA-will be eliminated. Targeted IRA Relief The combined impact of TIPRA and PPA on individual retirement accounts is significant.  By making the EGTRRA contribution levels a permanent part of the Tax Code and then enhancing IRAs in a number of different ways, IRAs become a key component in the majority of Americans' retirement savings strategy.  Some IRA changes under the new laws affect a relatively small segment of taxpayers but are extremely significant to those affected.  Other changes will be able to be used effectively by literally tens of millions of taxpayers. Higher Contribution Limits Under the new law, the higher IRA contribution limits that are being phased in by EGTRRA will continue and, in addition, will then increase annually for inflation in $500 increments.  They apply to all types of IRAs:  traditional, nondeductible and Roth. 2006                      $4,000 IRA contribution allowed 2007                      $4,000 IRA contribution allowed 2008                      $5,000 IRA contribution allowed 2009 and later      $5,000 plus $500 increases for inflation To bolster tax-favored retirement savings for those 50 years of age or older, the new law permanently continues so-called "catch-up" contributions.  That provision allows an additional $1,000 per year contribution out of earned income. Direct Payment of Tax Refunds to IRAs To encourage greater retirement savings, you will be able to direct the IRS to deposit all or part of your tax refund directly into your IRA account.  Beginning with returns filed in 2007, the IRS must make available a form or modify an existing form to enable this direct deposit to happen.
CAPITAL GAINS AND INVESTMENTS Qualified Dividends Qualified dividend income will be included as part of net capital gain through 2010.  As a consequence, it is taxed at the lower capital gain rate.  If this special treatment had not been extended, dividend income received by noncorporate taxpayers would have been taxed at higher ordinary income tax rates of up to 35 percent starting in 2009.  Qualified dividends are dividends paid by domestic corporations and qualified foreign corporations on stock held for a minimum period of time.  The minimum holding period is at least 61 days for the 121-day period beginning 60 days before the ex-dividend date.  Payments received from a mutual fund, partnership, real estate investment trust and certain other entities may also qualify as qualified dividend income. The capital gains (and qualified dividends) rates are summarized in the table below.   2006-2007 2008-2010 After 2010 Capital gains rate generally 15% 15% 20% Capital gains rate for taxpayers in the 10% or 15% income tax bracket 5% 0% 0% Capital gains rate on five-year property 15% 15% 18% Capital gains rate on five-year property for taxpayers in the 10% or 15% income bracket 5% 0% 8% Qualified dividend rate 15% 15% N/A Qualified dividend rate for taxpayers in the 10% or 15% income tax bracket 5% 0% N/A Alternative Minimum Tax on Sales of Small Business Stock Special alternative minimum tax (AMT) treatment of the gain from the sale or exchange of qualified small business stock will continue through 2010.  As it has always been, 50 percent of the gain on a sale or exchange of qualified small business stock is excluded from gross income.  However, under the temporary EGTRRA-created AMT rules, only 7 percent of the income exclusion is treated as a tax preference item.  If this special rule had not been extended, the tax preference item would have been 42 percent of the income exclusion starting in 2009. Capital Gains Treatment for Self-Created Musical Works The capital gains tax rate applies only to a sale or exchange of a capital asset.  A musical composition (or a copyright in a musical work) is not a capital asset when it is held by the person who created it.  Therefore, a gain from sale or exchange of the work by the composer would be treated as ordinary income.  Under TIPRA, this treatment is no longer required.  Instead, a composer (or other qualifying taxpayer) may elect to treat this as a sale or exchange of a capital asset. The electing taxpayer can be the one who created the work or a person that has a basis in the work that is determined by reference to the creator's basis (for example, as a recipient of a gift).  The election has a limited duration (unless it is extended by Congress).  It is available for a sale or exchange occurring in a tax year that begins after May 17, 2006, but in any event the sale or exchange must occur before January 1, 2011.
CHANGES FOR BUSINESS Amortization of Musical Compositions The income forecast method of depreciation no longer is required for the capitalized costs of creating or acquiring a musical composition or copyright.  Instead, the taxpayer may elect to amortize the expenses over a five-year period.  The amortization period begins with the month in which the composition or copyright is placed in service.  The election can be made one year at a time.  Once made in any particular year, the five-year amortization will apply to all musical compositions and copyrights placed in service during that tax year. If the taxpayer does not elect five-year amortization, any allowable cost recovery method, including the income forecast method, can be used. Unless Congress extends the rule, property must be placed in service before January 1, 2011 for 5-year amortization. Charitable Contributions Made by an S Corporation For a limited period of time to encourage charitable contributions in a sector of business often ignored, the S corporation, a modified rule will apply to benefit of S corporation shareholders when the corporation makes a charitable contribution of property that has appreciated in value. A shareholder's basis in S corporation stock must be reduced when the corporation makes a charitable contribution.  Until now, the amount of basis reduction has been determined by the fair market value of the contributed property rather than its usually higher fair market value. The modified rule for stock basis adjustment applies to charitable contributions made in tax years that begin after December 31, 2005, and before January 1, 2008.
PENSION CHANGES Making Temporary EGTRRA Changes Permanent The Economic Growth and Tax Relief and Reconciliation Act of 2001 (EGTRRA) generously increased a number of retirement plan contribution and benefits limitations as well as a number of rollover limitations.  These generally took effect after 2001.  For example, the 401(k) elective deferral limit went from $10,500 in 2001 to $15,000 in 2006.  These changes were scheduled to sunset along with EGTRRA after 2010, at which point the old rules and limits would again apply.  Thankfully, the Pension Act makes the EGTRRA retirement plan changes permanent.  Some of the EGTRRA features the Pension Act makes permanent include: Increases in the annual benefit limit under a defined benefit plan ($175,000 for 2006); Faster vesting of employer matching contributions (full vesting under three-year or six-year schedules); Greater portability for 403(b) and 457 plans; Higher deductible amounts for employer contributions to employee retirement plans (inflation-adjusted to $220,000 in 2006; 25-percent compensation deduction limit for stock bonus and profit sharing plans); Roth 401(k) and 403(b)s; Start-up tax credit for new small employer-sponsored plans (maximum $500/year for each of the first three years); Deemed IRAs set up under an employer plan allowing separate employee contributions; Credit for pension plan start-up costs of small employers; ESOP enhancements; and Modifications to the top-heavy nondiscrimination and coverage rules. Automatic 401(k) Enrollment With the shift away from employer sponsored defined benefit plans, employees have to rely more and more on their 401(k) savings for retirement benefits.  Meeting savings goals, however, is something that most find hard to do. Some employers who have needed to recruit lower paid employees into their plans have found a way to combat the normal reluctance to save.  They have made 401(k) participation the default position for new employees.  If employees want to opt out of having a pre-tax amount taken out of their paychecks, they can, but they must act.  There is evidence to suggest this approach does work to increase plan participation.  However, many employers have been concerned about the potential fiduciary liability from having to select a default portfolio for the employee. With the Pension Act, Congress has stepped in to help promote automatic enrollment by providing a nondiscrimination safe harbor for elective deferrals and matching contributions for plans that include an automatic enrollment feature.  To qualify for the safe harbor, the plan must provide certain contribution percentages.  The percentage cannot be more than 10 percent and must be equal to at least three percent of compensation for the first year the deemed election applies to the participant, four percent for the second plan year, five percent for the third year, and six percent for the fourth and subsequent years. Planning Tip:  Automatic enrollment is particularly attractive for plans that have discrimination problems due to low participation by lower paid employees. Plan Investments Enron continues to impact legislation passed by Congress.  New rules under the Pension Act require defined contribution plans to allow participants to diversify out of employer securities into other investment options.  A participant in a plan with at least 3 years of service or a beneficiary of such a participant must be able to elect to divest the portion of the account invested in employer securities that is attributable to employer contributions in other investment options. Rollovers EGTRRA Rollover Changes Made Permanent The Pension Act makes the following EGTRRA rollover provisions permanent: Rollovers among various types of plans. Eligible rollover distributions from a qualified retirement plan, a 403(b) annuity, or a 457 government plan can be rolled over to any similar plan or arrangement. Rollovers of IRAs into workplace retirement plans. An eligible rollover distribution from an individual retirement account may be rolled over into a qualified employer plan, a 457 deferred compensation plan, or a 403(b) annuity. Rollovers of after-tax contributions. An employee may roll over after-tax contributions from a qualified plan to certain other qualified plans through a direct trustee-to-trustee transfer. Automatic rollover of involuntary distributions. A direct rollover is the default option for certain involuntary distributions. Hardship exception to 60-day rule. The IRS is permitted to waive the 60-day rollover period if failure to make a wavier be against equity or good conscience. Early Distributions Phased Retirement As the line between work and retirement progressively blurs, Congress has given a boost to phased retirement programs.  Under old law, a qualified pension plan could not allow an employee to start drawing on pension benefits before normal retirement age unless the employee had separated from employment.  Starting in 2007, the Pension Act allows a pension plan to provide for a distribution to an employee who has attained age 62 even if the employee has not yet separated from employment.  The employee must be in a phased retirement program. Military Reservists No Americans have sacrificed more in recent years than military reservists and members of the National Guard.  In return, Congress has waived the 10 percent early withdrawal tax for these taxpayers for distributions taken from their IRA, 401(k), and 403(b) plans during their tours of active duty.  The waiver applies for such tours of duty only if the taxpayer was called up between September 11, 2001, and December 31, 2007, and only if the tour of active duty was in excess of 179 days or for an indefinite period.  The dollar limitations that apply to contributions to such plans is waived for two years after the end of the active duty period so they can repay the distributions if they so choose. Police, Fire and Emergency Workers Qualified public safety employees, who separate from service, may take distributions from government pension plans without being subject to the 10-percent early withdrawal penalty tax after age 50.  Previously, the age was 55.  In addition, up to $3,000 of otherwise taxable distributions from a government pension plan may be excluded from income annually if used to pay for qualified health insurance premiums of retired public safety officers. 401(k) Hardship Withdrawals The Pension Act makes permanent the EGTRRA rule allowing 401(k) plans to allow for early withdrawals for hardships and unforeseen financial emergencies with respect to a spouse or dependent.  The Pension Act goes further and instructs the Treasury to issue rules that allow early such withdrawals for hardships and unforeseen financial emergencies with respect to any person who is listed as a beneficiary under the 401(k) plan.  The Treasury rules are to be consistent with hardship withdrawals now allowed for spouses and dependents. Other Savings Incentives The Pension Act makes permanent the following EGTRRA savings provisions: Higher dollar amount for IRA contributions ($4,000 starting in 2006, $5,000 in 2008, inflation adjusted thereafter), 457 plan deferrals ($15,000 in 2006), SIMPLE plan contributions ($10,000 in 2006) and compensation that may be taken into account under a plan; Catch-up contributions for older workers ($1,000 after 2005 for IRAs, $2,500 for SIMPLE plans, $5,000 for 401(k) plans); and Qualified retirement planning services. The $1,000 IRA catch-up contribution amount is not adjusted for inflation.  The $2,500 SIMPLE and $5,000 401(k) catch-up amounts are adjusted, in $500 increments. In addition, the Pension Act makes permanent the soon to expire Saver's Credit.  This credit allows lower- and middle-income taxpayers to claim nonrefundable tax credit for their contributions or deferrals to retirement savings plans and IRAs.  The new law also permanently extends the rules allowing for qualified tuition programs.  Starting out slowly after EGTRRA, "Section 529 plans" have taken off recently, with current taxpayer funds in those plans doubling during last year alone. The Pension Act now allows government employees to purchase permissive service credit that relates to benefits to which they are not otherwise entitled under a governmental plan.  Service as an elementary or secondary school employee is determined under the law of the jurisdiction in which the service was performed.  The limitation on nonqualified service credit does not apply to trustee-to-trustee transfer from a 403(b) or 457 plans to a governmental defined benefit plan to purchase permissive service credit.