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New Law Could Save More Tax Dollars... by Stephen C. Smith, CFC®

Many Americans cheered passage of the IRS Restructuring and Reform Act of 1998 in hopes of getting a tax agency that was more fair and responsive. But did you know that the law also enhances several tax breaks that may help free up more money for your financial goals?

Part of the act, signed into law in July 1998, provides “technical corrections” to provisions of the Taxpayer Relief Act of 1997. In addition to changes that affect Roth IRA conversions, there are other changes that may affect your finances.

A shorter capital gains holding period. The law shortens the securities holding period required to qualify for the most favorable capital gains tax rate from 18 to 12 months - this essentially reestablishes the holding period that was in force prior to the Taxpayer Relief Act of 1997. The change is retroactive to the beginning of 1998.

Last year’s tax relief act lowered the most favorable capital gains rate to 20 percent (10 percent for taxpayers in the 15 percent income tax bracket) but extended the required holding period to 18 months. The result was a complex multi-tiered holding period/tax rate structure that was confusing.

A few mutual fund investors may still be subject to tax at 28 percent or 25 percent, however. That’s because some of the gains distributed by funds in 1998 could include gains made from securities sales early in 1997 or gains from the funds’ sales of other assets, like gold or REITs.

A larger exclusion for some home sellers. For homeowners who sell their residence after living there less than two years, the new law allows a capital gains tax break based on a portion of the maximum exclusion passed in 1997 ($500,000 for joint-filing couples and $250,000 for singles who live in their homes at least two years prior to the sale) - provided the move is due to a job change, for health reasons, or “unforeseen circumstances.” The provision is generally effective for sales after May 6, 1997.

For example, if you live in a home for one year before selling it to move to a new job (one-half of the required period), you’ll qualify for one-half of your maximum exclusion ($250,000 if you’re a joint filer).

Before the act’s clarification, the Taxpayer Relief Act was interpreted to allow people who were selling their houses after less than two years to exclude a fraction of their realized home-sale profit rather than a fraction of the maximum exclusion.

Estate tax changes. The new law also:

• provides computations that coordinate the increase in the unified credit (from $600,000 in 1997 to $1 million in 2006) with a decrease in the family-owned business (exclusion also becomes a deduction in the new law!). This change will ensure that the total tax on estates with family-owned businesses neither increases nor decreases as the unified credit moves up.

• clarifies that gifts for gift-tax purposes cannot be valued differently for estate tax purposes if a tax return for the gift was filed and the statute of limitations period expired, even if no gift tax was paid on the gift.

• makes clear that interest in property won’t be disallowed as an interest in a family business even if the deceased owner leased it to a family member for use in a business or trade.

How to benefit from the changes. Tax laws have shifted considerably over the last two years, with a range of new opportunities available. To take full advantage of the changes, consider reviewing your situation with a knowledgeable financial advisor and your tax advisor. Together you can create a financial plan that makes the most of current tax laws in achieving your goals.

Investing Business Reserves: Make Your Money Work For You. You’ve made it through the toughest time for a small business - getting started. Now your business is profitable and you’ve built some cash reserves. If so, it may be time to consider an investment strategy that can potentially generate competitive returns within your own risk “comfort zone” and keep your reserves hard at work.

Keeping all your assets working for you is an important strategy and a key contributor to overall portfolio performance. For short-term assets, here are some alternatives to consider:

Interest-bearing checking accounts. If you keep a sizable amount of cash in a checking account, make sure it pays interest. Interest-bearing checking accounts are the simplest method of investing cash reserves and they allow easy access to your money. Interest earned by the account is usually based on the average daily balance in the account. Bank accounts are FDIC insured.

Money market funds. Money market funds invest in short-term securities and minimize risk by diversifying investments. They also provide easy liquidity and money can usually be withdrawn immediately or on a one-day notice.

Brokerage accounts should not be used this way. The sweep account feature is for short-term use between investments, and if used any other way the SIPC protection would be void.

These “cash” assets are a staple in most every business owner’s investment portfolio. But it’s important to balance their low risk and reward features with other asset classes that offer higher potential return.

A strategy called asset allocation can help determine the appropriate asset mix for your overall portfolio based on your goals and show you how to reduce risk by spreading your dollars across a variety of investments. By meshing state-of-the-art technology with established investment principles, a knowledgeable financial advisor can utilize an asset allocation program to help you evaluate your existing investments, make adjustments to your current portfolio and structure a longterm investment strategy.

What drives portfolio performance? According to Financial Analysts Journal, May-June, 1991, asset allocation accounts for fully 91% of portfolio performance - while security selection, marketing timing and all other factors account for less than 9%. When developing an asset allocation strategy, you will need to consider the following:

• When you will need to use your money. Will you need the money to pay for inventory in six months or will it be used to replace antiquated machinery 10 years from now?

• Your personal and business tax brackets. Your overall tax situation can help you determine your tax-deferred and tax-exempt investment strategy.

• Your time frame for personal and business goals. It’s important to take into account things like your growth plans for the business and your own retirement goals.

• Your risk tolerance. Your tolerance for risk can and probably will change over your lifetime. That’s why it’s important to regularly review your asset allocation strategy to make sure it includes the right amount of risk so you can reach your goals and still sleep at night.

With all the stocks, bonds, mutual funds and specialized investment products on the market today, the choices facing business owners can be overwhelming. That’s why creating a plan for investment of your cash reserves and sticking with it can offer you peace of mind and let you focus on the success of your business. A financial advisor can be a valuable asset in helping you navigate through the many complex investment decisions that affect not only your business, but your personal life as well.