Yearend planning for individuals and small businesses; how to make the most of this year's limited opportunities.

The tax law changes of recent years succeeded in eliminating aggressive noneconomic tax advantages and shifting the tax burden to those individuals government believes are most able to afford it. At the same time, the "tax simplification" that was the main selling point of both the Tax Reform Act of 1986 and subsequent modifications to it has not really been achieved.

Although these changes created challenges for CPAs, there are still yearend tax planning opportunities available. This year is notable because it marks the final phaseout of several opportunities the TRA sought to end and because it seems clear taxes will increase in the future. This article, which went to press before any budget accord was reached, tells what's ahead in the coming tax season. CPAs should monitor legislative activities to see what effect they'll have on clients.

PLANNING FOR INDIVIDUALS

While some new items are really variations on and old theme, planners must keep them in mind. The tax rates remain at 15%, 28% and 33%. Inflation indexing, however, has caused the amount covered in each bracket to rise.

High-income taxpayers will continue to lose their personal exemptions as their incomes increase. The 33% bracket was created to eliminate the benefit of the 15% bracket for people earning above certain amounts so all their income would be taxed at a flat 28%. However, when their income level eliminates their exemptions, the tax rate goes highger. A main goal of yearend tax planning should be to soften the effect of the 33% bracket (see exhibit 1 on page 64 to understand this bracket's impact).

The personal exemption has increased to $2,050. The standard deduction is now

  Married, filing jointly       $5,450
  Married, filing separately    2,725
  Single                        3,250
  Unmarried head of household   4,750

Additional standard deductions are available for taxpayers over 65 and fr the blind.

In addition, new rules limit the usefulness of like-kind exchanges between related people that are made after July 19, 1989. (For further information, see "Finally, Guidance on Like-Kind Exchanges," by Philip J. Wiesner and David G. Meulmester, part 1, JofA, Oct.90., pages 50-59, part 2, Nov.90, pages 76-84.)

SPECIAL CONCERNS

A few areas deserve special attention this tax season:

Interest deductions. Tax planners must remember the key to tax deductibility is not necessarily where the borrowed money comes from but how the funds are used. There are several different kinds of deductible interest:

* Interest on residential mortgages is deductible up to $1 million of acquisition debt, plus $100,000 of home equity debt. Planners should remember that an acquisition debt can be refinanced but the interest expense is deductible only on the balance existing on refinancing, plus the home equity debt (if available).

Clients should take care when financing the purchase of a second home with money borrowed against their principal residence--some or all of the interest may not be deductible. Exhibit 2 on page 66 summarizes the rules on vacation homes. Planners also must be familiar with the "grandfather" rules for residential debt acquired before October 13, 1987.

* Investment interest is deductible up to net investment income plus 10% of remaining investment interest up to $10,000. It must be emphasized that one of the biggest planning mistakes is using money borrowed from security margin accounts for personal purposes. This interest expense would be considered personal and subject to the personal interest limitation.

It is possible to structure transactions to guarantee an interest deduction. For example, a client has a money market mutual fund, which is considered an investment income source. She also has a brokerage security account. She needs $5,000 for personal purposes. By transferring $5,000 from the margin account to the mutual fund, she turns the interest on the margin account into investment interest expense. She could then withdraw $5,000 from the mutual fund for personal use without facing the personal interest deduction limitation.

Planners also must be aware of what items are to be included in the calculation of net investment income.

* Passive interest is governed by the passive activity loss (PAL) rules, which are discussed later in this article.

* Business interest generally is fully deductible. Care must be exercised to be sure activities are not passive.

* Personal interest is the biggest loser in this category. It is deductible only up to 10% in 1990. In 1991, none of the interest will count. There are many possibilities when planning how borrowed funds should be used. The Internal Revenue Service's tracing rules (contained in notice 89-25) can be onerous. The planner must understand them and remind clients of the importance of proper documentation and the possible need to segregate loans before final use.

Kiddie tax. A new wrinkle has been added to the kiddie tax since the TRA created it. Beginning in 1989, parents were allowed to include on their own tax returns the income of children under 14. The election is available if the child's income is from interest and dividends only and is under $5,000. The income is taxed as if the child filed his or her own return (first $500 is tax free; second $500 at 15%; the rest taxed at parent's rate).

One good reason not to make this election is that the child's incme may be taxed on the taxpayers' state and local tax return at a higher level than it would have been seperately. Remember also that any earned income over $500 can increase a child's standard deduction up to a limit of $3,250.

There are a number of strategies for avoiding the kiddie tax, including

* The new U.S. higher education bonds. Interest is tax free, although this benefit is phased out on joint returns between $60,000 and $90,000 and single returns between $40,000 and $55,000. The bonds must be owned by the parents and the proceeds must be used for the student's higher education expenses.

* Regular U.S. savings bonds and other deferred income instruments, as well as tax-free municipal securities. If children are given these a gifts, the interest they earn on them avoids the kiddie tax.

* Hiring the children in a family business. Parents can hire children under age 14 part-time and ensure that their annual pay is less than the standard deduction. Once the child reaches age 14, the kiddie tax disappers. The child may then earn up to $19,450 and pay only 15% in federal taxes. Clients should be reminded of the opportunity to shift income to those children who are over 14.

Alternative minimum tax. The AMT continues to cause the most surprises in tax planning. The AMT tax rate is 21% and there are exemptions (which phase out with increasing income) of $30,000 on single returns and $40,000 on joint returns.

Here are some recommendations for clients who might be subject to the AMT:

* Accelerate income.

* Delay early payment of state and local taxes and other deductions that would not be usable.

* Spread out charitable gifts of appreciated property using the straight-line depreciation method.

* Take care when investing in private-purpose bonds to avoid taxable income.

In choosing 1990 AMT strategies, remember the effect of the AMT credit (available only in years when the regular tax is paid) and possible higher future taxes. It may be a good idea to accelarate income if the taxpayer is subject to the AMT in the current year.

PASSIVE ACTIVITY LOSSES

This tax season is the final one for realizing any benefits for passive activities that took place before October 23, 1986, because the phase-out percentage--10% this year--drops to zero in 1991.

Activities entered into before October 23, 1986, now are creating "phanton income," which can be used to offset the suspended losses. While phantom income can help make use of passive losses, CPAs must be aware of how the income is generated. Many investment programs now reporting phantom income are returning little or no actual cash. A lot of phantom income also is caused by the recapture of the benefits of passive real estate investment in which the property has been foreclosed. Planners must review client's passive investments to ensure there are no major surprises.

The most important element of the PAL rules today is the determination of a passive activity. Some, such as real estate, leasing and limited partnership intersests, are defined as passive while others mandate a determination based on the amount of participation.

CPAs should remember the PAL rule's $25,000 limitation on active real estate losses, particularly when working with clients with incomes over $100,000, which is the beginning of the phaseout of allowed losses. A second or vacation home can be used in this planning, when working with high-income taxpayers.

* Convert passive activities to active by changing client's material participation,

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particularly if passive activities have component parts.

* Accelerate income to offset PALs, which also helps avoid the AMT.

* Look for economic passive income activities.

* Transfer passive activities to C corporations, which can deduct PALs. Closely held coporations (CHCs) that aren't personal service corporations (PSCs) can deduct PALs up to earned income. Those that are PSCs probably will face an AMT. Principals of other entities, such as S corporations, partnerships, etc., are subject to PAL rule on their individual returns.

* If possible, dispose of passive activities that won't return future economic income.

* The best overall advice is to close out unproductive passive investments made before October 23, 1986, and take care with investments made since then.

TAX PLANNING STRATEGIES FOR

INVESTMENTS

Planners generally should attempt to defer gains on investments no matter whether Congress passes a capital gains tax reduction in the near future. To achieve this goal, CPAs should consider the following:

* Defer income recognition on certain transactions.

* Use installment sales (where applicable).

* Use bond swaps, which may allow loss recognition, but which shouldn't be "wash sales."

* Structure investments to lock in deferred gains.

* Recognize actual losses by selling securities (remember the loss limit).

* Make tax-free investments.

* Use investments, such as U.S. Treasury bills, that mature upon some date in the future.

When working with mutual funds, practitioners also must remember that there are two ways to achieve gains or losses. One is reported on the form 1099 received by the taxpayer. The second is realized when the client redeems mutual fund shares--such redemptions are not reported on the year-end 1099. In addition, the cost basis of the mutual fund or any part thereof is increased by any income reported to the taxpayer on the 1099 (including tax-free income).

Oerall, any attempts to defer and/or recognize income because of possible tax cuts or increases shouldn't affect investment advice to the client. Investment strategy tax planning should emphasize economic goals over tax considerations.

VACATION HOMES

Exhibit 2 summarizes the effect of a vacation home on tax planning. Planning decisions for vacation homes can affect many other areas, including passive activities (rental), investment interest expense, real estate tax deductions, personal interest expenses and the AMT. CPAs should examine many scenarios to produce the best overall result for clients.

SMALL BUSINESS

Small business yearend tax planning has been altered by recent tax law changes. In 1990, small business planners should be aware of the following changes:

* Deductibility of self-employment tax. This tax--15.3% of self-employment income--is partially deductible for the first time in 1990. Clients may either deduct 50% of the tax from their adjusted gross incomes or reduce taxable self-employment earnings by 7.65%.

* End of completed-contract method for long-term contracts entered into after July 11, 1989. There are some exceptions for residential contractors and other small contracting companies.

* The need to attach the appropriate forms for noncash contributions on returns for S corporations and partnerships.

* The increase in the maximum 401(k) contribution to $7,979.

* The end of the four-year phase-out for "bunched" income. Back in 1986, when S corporations, partnerships and trusts generally had to change to a calendar yearend, they filed two tax returns: their regular fiscal-year return and a special short-year return to December 31. The short-year income could be reported at a 25% annual rate from 1987 to 1990.

* Establishment of a corporate AMT credit.

In addition to the new items, small business tax planners continue to monitor changes brought about by the TRA as well as standard yearend planning items:

* Interest tracing rules.

* PAL rules.

* Cash basis: C corporations with average annual gross income of $5 million or more for the three prior years can't use the cash basis.

* Uniform capitalization rules.

* Rules on "material participation."

* Fiscal-year selection.

* Income deferral or accelaration of expenses, if applicable.

* Using maximum depreciation (careless timing of acquisitions could reduce the 1990 benefit, however).

* Using 401(k)s and other benefit programs.

* Accrual of bonuses and salaries to pay after yearend (watch the special rules for CHCs and PSCs and the time limits).

* Providing fringe benefits to employees (see exhibit 3 below).

* Investing in dividend-paying stocks to save taxes for C corporations.

* Amortizing start-up expenses over 60 months.

* Ensuring S corporation and partnership owners have enough basis to cover any losses generated by the entity.

* Checking rules to ascertain use of income to offset PALs. S corporation income could be passive if a shareholder is not a material participant.

* Splitting PSCs into component companies to avoid higher taxes.

* Determining which tax credits are still available.

SMALL BUSINESS OWNERS

Tax law changes of recent years have forged an even stronger link between owners and their businesses. Strictly on a tax basis, a one-person business probably could operate as a proprietorship or a corporation with no real tax difference. (Planners still generally prefer the corporate form because of limited liability and other benefits). When deciding on an entity type, consider a number of factors, especially since repeal of the General Utilities doctrine.

The man yearend tax goal for a small business is to have little or not taxable profit. This is accomplished by paying salaries and bonuses and providing benefits programs. Bear in mind that strict rules apply to these strategies--particularly for PSCs--and a misstep or wrong timing in application of the rules could be expensive.

WHAT LIES AHEAD

A good tax plan is in place long befor yearend and should be updated constantly. The common wisdom has it that in the future tax rates will increase, rules will be tightened and the tinkering with tax laws will continue to create new sources of government revenue. As a result, clients will continue to depend heavily on well-informed CPAs. While the practitioner's task may appear more difficult, this situation offers a challenge to CPAs to be creative and to exercise our best professional judgment.

STANLEY PERSON, CPA is managing partner of Person & Co., New York City. The chairman of the American Institute of CPAs continuing professional education standards subcommittee, he is also editor of the Journal's Practitioners Forum department.