April 28, 2006

Dear Client:

Small-cap and foreign equities continued to lead the pack, with 13.9% and 9.4% gains respectively. U.S. large-cap stocks gained a more modest 4.2%, while bonds lost 0.7% in response to rising interest rates.

Three-year returns show a tremendous increase. Although investment returns since April 2003 have been very high, three year returns have been weighed down by the negative returns of April 2002 through March 2003, in which major equity indices lost between 24% and 27%.

Look at what happens to the three year results when losses ending in March 2003 roll out of the three-year period: equity returns increase between three and five fold:

A few words from the bully pulpit... Compliance with the Internal Revenue code becomes more difficult each year. The sheer volume of regulations is mind-boggling. Here are a few examples of the challenges faced by taxpayers who wish to comply.

A reduced tax rate of 15% was introduced in 2003 for qualified corporate dividends. How do we identify a qualified dividend? First, the company that pays the dividend must be a domestic or "qualified" foreign corporation. The dividend must be paid out of taxable earnings and cannot be essentially an interest payment, e.g., by a mutual savings bank.

Next, the holding period of the dividend-paying security must be examined. For a stock dividend, the owner must hold the stock for 61 continuous days within a 121-day period, beginning 60 days before the ex-dividend date (how many individual investors even know what the ex-dividend date is?). For a mutual fund, first the mutual fund must meet the 61-day holding period requirement, then the investor must meet the same holding period requirement of the mutual fund shares themselves.

The last step of reporting qualified dividends is perhaps the most misguided of all. Mutual funds are required to report dividends to shareholders by January 31st. If your funds are held by a brokerage firm (Fidelity or Schwab, for example), the brokerage firm compiles dividend information from all of your mutual funds and creates a Form 1099-DIV. Guess what day the brokerage firms are required to mail the 1099s? You guessed it - January 31st, the very same deadline for receiving that same information from the mutual funds.

This is the reason that shareholders are getting multiple revisions of form 1099-DIV. This year, a revision was mailed to some taxpayers on March 23, 2005. Each of the officially-sanctioned alternatives for properly reporting the dividends increase the time (cost) required to prepare your return (the alternatives are last minute filing, an extension request or on-time filing followed by an amendment to the original tax return). Deciding to ignore it may result in an inquiry letter issued by the IRS, with concomitant time required by you and your accountant to respond.

During his campaign, John Kerry released his 2003 tax returns for public scrutiny. One reviewer identified an error in Kerry's return: he reported tax on the sale of a painting at the new 15% capital gain tax rate, when it should have been taxed at 28% as a collectible. The error was $11,600 in Kerry’s favor, out of a $102,000 tax liability. I would guess John Kerry has more than one accountant looking at his return, doing their best to comply with all of the regulations without cutting corners. You can be sure that other accountants are making honest mistakes as well and not always in the client's favor.

My last example of money down the drain is of a client who is an investor in a venture capital partnership. The partnership made a distribution in 2005 that was taxable in a state other than the client's state of residence. The client's share was a $300 distribution with a $15 tax in the non-resident state, a $15 credit in his resident state for the tax paid, and a $400 preparation fee for the additional state tax return.

On tax underpayment penalties. I hereby start a campaign to have the Internal Revenue Code replace references to underpayment penalties with underpayment interest. There are no penalties. There is only interest on the difference between the required minimum payment and your actual payments.

The rate that applied to most of 2005 was 6% (it increased to 7% on October 1, 2005). The interest is charged on each quarter's underpayment for the number of days the payment was late using the annual rate. For example, if the calculated tax for Q1 2005 was $10,000 and the payment was made 30 days late, the interest charge for Q1 would be $50.

But while you are underpaid you have had the investment use of the money. If your accounts were fully invested in 2005 you would have profited from underpayment. In fact, some investors choose to keep their money working for them instead of making the payments.

Capital gains on home sales. Some taxpayers owe tax on sales of their personal residences. Before May 1997, capital gains on home sales were treated differently than they are now. Gains realized at sale could be indefinitely deferred if a new home was purchased. At age 55, a one-time exclusion from tax was granted for up to $155,000(!) of capital gain if the deferral criteria were not met.

In 1997 the rules changed: as long as a taxpayer owns and lives in their primary residence for at least two of the five years prior to sale, $250,000 of capital gain is exempt from tax ($500,000 for married couples). When first enacted, there were whispers of a few wealthy people who might owe tax some day; but I never saw it on a tax return.

Fast forward to 2006, and $500,000 of gain from purchase to sale is not a bit unusual. In addition, the gain calculation includes deferred gain from pre-1997, i.e., if you had deferred gain under the old rules, the amount of that gain reduces the cost basis of your post-1997 home.

Be sure to maintain records of capital improvements made to your home. When you ultimately sell your home, the tax savings may be significant.

Regards,

Audrey Grubman