Millenium Mush

More posturing than a Rodin sculpture . . . . .

Enough hot air to cause global warming . . . . .

More baloney than the Hillary Clinton sandwich . . . . .

What is it? The interplay between the Republicans and Democrats over fiscal policy on the eve of the year
2000 presidential election.

We were treated to the spectacle of having the both political parties offer legislation that had absolutely no
chance of enactment. Both sides were using the legislative process to stake out campaign positions. The
Republicans, having a majority in both houses of Congress, are generally able to pass legislation directed at
pleasing their voting constituency. President Clinton’s response is to advertise things that will be vetoed in
advance of the votes in Congress. The veto threats haven’t deterred the Republicans from going through the
motions for their supporters.

The opposing reaction from the Democrats is to propose things that will surely be voted down by the Republicans,
either in committee or on the floor of the House of Representatives. This also makes good fodder for the
campaign trail. (Hey, we tried. Just kick out those nasty Republicans next year.)

The gorilla in the closet that both parties find impossible to face up to is the funding of the Social Security
system. Through indexation, the pension portion of the system has evolved into a claim of 12.4% on the
national income. This is the combined employer-employee tax on wages, exclusive of Medicare taxes, and
represents defined benefit retirement plan contributions.

In recent years, the wage base against which Social Security taxes are levied has increased at a much quicker
rate that inflation, as expressed by the Consumer Price Index (CPI):

Representatives of the government are quick to point out the perceived tameness of inflation during the current
economic in the CPI figures. Few want to take credit for the dramatic increase in Social Security taxes that
outpaces the rate of inflation.

For many taxpayers, especially two income families, Social Security taxes are a heavier burden than the income
taxes. Income taxes are levied on taxable income after housing deductions (mortgage interest and real estate
taxes), deductible medical expenses, and personal exemptions. The beauty of the income tax is, as we have often
noted, that you only pay it if you have income. Having taxable income is a measure of one’s ability to pay.

Social Security taxes on wages, in comparison, are levied without regard to deductions. They are levied on the
first dollar of wage income. If individuals have large expenses that impair their ability to pay, such as having
dependents or medical expenses, the income tax burden is reduced, but not the Social Security taxes.

The sharp increases in the Social Security wage base should set off alarm bells in the minds of taxpayers. The
only way to avoid this tax is to reduce reliance on wage income. Individuals with high living expenses relative
to income are putting themselves on a treadmill, since their earned income must fund both living expense and
retirement reserves. If this source of income gets taxed at higher rates it makes the job of funding retirement
more difficult.

Individuals with high savings rates who manage to accumulate capital can be very successful in avoiding these
taxes, either through tax deferred earnings in IRA’s and retirement plans, or through investments that generate
capital gain income. However, the process of diversifying away from a reliance on earned income requires patience
and discipline over a long time period, something that the general public doesn’t seem to have in reserve.

All this horsing around in Washington has merely served to distract the taxpaying public from the key fiscal
issue of the millennium year, the tax and benefit policy of our national pension system. As you watch the
presidential and congressional campaigns, look for the candidates who support making Social Security work
like an pension plan, not those who want to turn it into an open ended income redistribution device. Your vote
could affect your ability to fund your retirement.

1999 Year End Tax Planning: Special Items

1. Taxpayers will be allowed to correct faulty Roth IRA conversions that were done in 1998.

   The IRS is trying to give taxpayers the benefit of the doubt because of the flurry of IRA law changes that took
   effect in 1998 (and led to widespread confusion on the part of taxpayers). Taxpayers can correct 1998 Roth IRA
   conversions if these corrections are done by December 31, 1999.

   Anyone who did a conversion from a regular IRA account to a Roth and watched in horror as the value in the
   Roth declined can reconvert the Roth back to a regular IRA. Another reason for reconversion would be if the
   taxpayer was ineligible because of Adjusted Gross Income exceeded $100,000.

   To reverse the effect of the Roth IRA conversion (which is termed a recharacterization), the taxpayer must
   notify the trustees of both the transferring account (the regular IRA) and receiving account (the Roth IRA),
   that the conversion should be treated as for federal income tax purposes and a transfer between two regular
   IRA accounts.

   Action: Taxpayers who made Roth conversions should look at the current value of the account and
   decide whether a reconversion would be beneficial. If so, notification to the trustees must be made by
   12/31/99, and an amended 1998 return filed within three years of the original filing.

2. Auto donations are being hit by an IRS audit program.

   In response to a torrent of contributions of autos to charitable organizations, the IRS announced that it will be
   scrutinizing these deductions. To claim a deduction the taxpayer must be able to establish the fair market value
   of the auto on the date of gift. Gifts of property that exceed $5,000 require a written appraisal. Blue book value
   by itself is not adequate proof of FMV.

   Action: Even if auto deductions are below the appraisal threshold, taxpayers should do their best to
   document the value of the contributed autos.

3. With the increase in health insurance deductions, taxpayers should examine alternatives to operating
   as C corporations.

   The deduction for the health insurance of self-employed individuals is 60% through 2001, and is increasing to
   70% in 2002 before being 100% deductible in 2003. This deduction is available in computing Adjusted Gross
   Income. It is not subject to the 7.5% threshold that reduces medical expenses taken as itemized deductions.
   This deduction is not available if a taxpayer’s spouse benefits under another employer’s subsidized health insurance
   program. 2%+ shareholder-employees of S corporations are considered to be self-employed individuals.

   Taxpayers have used C corporations to make medical expenses fully deductible and to get the use of graduated
   corporate income tax rates. Starting in 1987, however, graduated rates have not been available to Personal
   Service Corporations (PSC’s) involved in law, accounting, consulting, etc. These corporations pay tax at the
   highest corporate rates (currently 35%).

   Maintaining C corporation status for a PSC is generally a nuisance because each year income must be zeroed
   out with deductible compensation payments. This wage declaration can act to subject additional income to
   wage taxes. (See the lead topic in this newsletter.) In avoiding employment taxes, it would be preferable to
   operate as an S corporation.

   Action: Incorporated business owners should evaluate whether it will be better to operate as an S
   corporation.

4. Home office deductions are back for 1999, but at a price.

   Home office deductions will be available for a home office used for administrative functions if no alternative
   site is available. The requirement that the space be used exclusively for business purposes has not changed.
   Claiming the home office deduction converts part of the home to a business asset. If the home is subsequently
   sold, the $500,000 exclusion will not be available for this portion of the gain.

   Action: Taxpayers with residences whose value exceeds its tax basis should steer clear of claiming home
   office deductions. Renters should try to take advantage of the new rules.