Roth & Company Tax Updates
Note: The Tax Updates home page has moved. Current Tax Updates may be found at www.rothcpa.com/taxupdates.php.
Thanks!
To receive the Roth & Company Tax Update by email, send an email with the topic "Subscribe" to News@rothcpa.com . To view the Tax Update FAQ (Frequently Asked Questions, go here
The items below are informational only and are not meant as tax advice. Consult with your tax advisor to determine how any item applies to your situation. Address questions or comments on Tax Updates to Joe Kristan.
NOVEMBER 22, 2002
NOW HE'S IN REAL TROUBLE
The American Institute of Certified Public Accountants has announced that it has
terminated the membership of Robert P. Hanssen of Vienna, Virginia, effective August 6,
2002, "because of a final judgment of conviction for crimes punishible by
imprisonment for one year or more."
More specifically, Mr. Hanssen spied for the Soviet Union and for Russia for
15 years while working for the FBI, until his arrest in 2001. His work led to the
execution of at least two U.S. agents in Russia, while revealing some of the FBI's most
sensitive intelligence to the Russians.
Mr. Hannsen will not even have the consolation of AICPA membership to help him get through
the long days of his life sentence — a grim
deterrent for any future Benedict
Arnold, CPA.
NO BASIS, NO LOSS: YEAR END PLANNING FOR S CORPORATION SHAREHOLDERS
S corporations have become very popular for a number of reasons. The biggest tax advantage
is the imposition of only one level of tax on S corporation income - at the time it is
earned. A schedule K-1 reports each shareholder's share of corporate income, which then is
reported on the shareholder's personal return. This income can be distributed tax-free to
the shareholder; if it is not distributed, it increases the shareholder's stock basis,
reducing the capital gain on any future sale of the stock. C corporations, by contrast,
pay their own tax on their earnings; the earnings are taxed again to the shareholders if
they are distributed as dividends.
If an S corporation has a taxable loss, that is also reported on the K-1. Here we must
consider a fundamental tax law principle: "Heads they win, tails you lose." In
other words, while shareholders usually must report taxable income from an S corporation,
there are several restrictions on the ability to deduct loss. Shareholders wanting to
deduct their losses have three hurdles to clear, in order:
1. BASIS. The taxpayer can only deduct an S corporation loss to the
extent of basis in the S corporation, or in direct loans by the taxpayer to the
organization.
2. AT RISK AMOUNTS: Is the taxpayer's basis "at-risk" under
the tax law?
3. PASSIVE LOSSES: Is the loss a "passive activity" loss,
deductible only to the extent of passive activity income?
You may be relieved to know that we will only discuss basis issues today.
A taxpayer's initial basis in an S corporation is the amount paid for the stock. It is
increased by capital contributions and by undistributed income of the S corporation. It is
reduced by distributions of S corporation earnings and by S corporation losses.
A taxpayer can also deduct losses of an S corporation to the extent of taxpayer loans to
the S corporation. The loans have to be loans made by the taxpayer; guarantees of debt do
not work.
EXAMPLE: Wally starts an S corporation. He contributes $10,000 to the corporation in
exchange for 100% of its stock. The corporation borrows $5,000 from Wally and $50,000 from
the bank, guaranteed by Wally. The S corporation loses $20,000 in its first year. Wally
can deduct $15,000 of losses this year, based on his $10,000 cash contribution and his
$5,000 personal loan. The guarantee from the bank does nothing to enable Wally to deduct
losses.
LESSON: Wally could have borrowed the bank loan personally and loaned it to the company;
this "back-to-back" loan would have given him enough basis to deduct the
remaining $5,000 S corporation loss.
Taxpayers need to be careful in dealing with S corporation basis. The basis is determined
on the last day of the S corporation's tax year. This means that the taxpayer needs to
project taxable income before year end to determine whether additional loans or capital
contributions to the corporation are called for.
Taxpayers also need to pay careful attention to how year-end basis contributions are
structured. The Oren case decided
earlier this year showed the
dangers of trying to shuffle basis among related S corporations. Now that
S corporations can be organized with holding-company structures, brother-sister S
corporations with identical ownership should normally be in a holding company structure.
ESTATE TAX REPEAL WATCH
The Wall Street Journal reports that Senator Grassley, the incoming Senate Finance
Committee chair, may like our recent bet:
"Mr. Grassley said that three components of Mr. Bush's tax package could win the 60
votes needed in the Senate to be made permanent: the marriage-penalty provisions, the
increase in the child tax credit and the repeal of the estate tax."
Of course, "could" doesn't mean "will." Stay tuned...
DON'T GO IN THE MARKET?
Well, an old saying holds that market bottoms are only called in hindsight, except by
liars and fools. We strive to be neither, so we won't say whether it is time to get back
into the market. We will say that if you do plan to put cash into your favorite mutual
fund, beware the dreaded "year-end mutual fund tax trap."
Mutual funds are required to distribute their recognized capital gains annually. They
usually do so in December. Yes, I know it sounds unlikely in this market, but there are
mutual funds that will have capital gain distributions for 2002. If you buy into a fund
just before year-end, you may buy into the year-end capital gain distribution. You can be
taxed for a whole year's worth of gains on stock you have held for as little as one day
before the distribution. You may as well wait until the distribution is made before you
buy, everything else being equal.
Many mutual funds post information about their year-end distributions on their web sites.
Bond funds are especially likely to have capital gain distributions this year.
Of course, if you want to do your fund buying in a tax-exempt IRA or 401(k), then the
year-end tax trap holds no terrors for you. That's good; the financial markets have
provided all the terror anyone needs lately.
DECEMBER 2002 AFRS ARE OUT
The IRS has issued the minimum rates to be charged for loans made in December 2002:
Short Term (demand loans and loans with terms of 1-3 years): 1.84%
Mid-Term (loans from 3-9 years): 3.31%
Long-Term (over 9 years): 4.92%
All historical AFRS are available on the “Links” page at www.rothcpa.com
NOVEMBER 13, 2002
THANKS, I FEEL A LOT
BETTER NOW
On
the second day after the end of his term as IRS Commissioner, Charles Rossotti heartily
endorsed his former employer by saying the IRS is "not quite falling apart."
According
to Tax Analysts, Rossotti put the IRS's difficulties in an
unusual perspective:
"'I
don't think we're in a current crisis,' Rossotti said, adding that compared to the to the
worldwide AIDS epidemic, the IRS's problems are 'much more solvable.'"
He
might have added that compared to the challenges we would face were Earth invaded by
shape-shifting brain-eaters from the planet Zargon, the IRS really has no problems at all.
Then again, people might have thought he was suddenly talking about the Osbourne family.
As
we have noted, the
recruiters trying to hire the next IRS Commissioner will probably try to keep former
Commissioners out of the process.
GIFT TAX VALUATIONS: NO DO-OVERS
While
final, final repeal of the estate tax may be a priority for the incoming Congress, it
isn't done yet; even if repeal happens, it is unlikely to take effect before 2010.
Meanwhile, we must cope with estate and gift issues as part of business planning.
Valuation
is the wild card for estate planning. Gifts and estates are subject to tax based on
"fair market value." With the exception of publicly traded stocks and some
other financial assets, "fair market value" can only be estimated. The tax
law says that fair market value is "the price at which the property would change
hands between a willing buyer and a willing seller, neither being under any
compulsion to buy or sell and both having reasonable knowledge of relevant facts."
Lacking
laboratories where hypothetical buyers can be matched with hypothetical sellers with
scientific precision, practitioners and appraisers apply various theories to come up with
an exact dollar value to put on a tax form. These are really guesses rounded to the
nearest 50 cents.
IS
VALUATION UNCERTAINTY A CERTAINTY? Taxpayers hate uncertainty. If a million
dollar gift is valued with a 40% discount for lack of marketability, the donor may be out
of pocket $200,000 if the IRS disallows the discount. So why not make the gift
conditional? Why not make the gift subject to a "savings clause" providing
that if the IRS adjusts the gift value, the donee has to give back any of the gift to the
extent the IRS increases the valuation?
This
was attempted in a gift recently examined by the IRS. A taxpayer established a family
limited partnership. The taxpayer sold interests in the partnership to a trust for
the benefit of her children, presumably at a discounted price, but requiring the price to
be adjusted to whatever value the IRS might adopt on examination. The IRS issued a
Technical Advice Memorandum (TAM 200245053) saying that gift tax on the increase was due
-- regardless of any requirement that the buyers remit any increased valuation back to the
seller.
Why doesn't IRS like
"savings clauses?" Well, if they worked, there would be no incentive
for IRS to examine gift values, because the savings clause would make taxable gifts
go away. Judges would find themselves operating as robed appraisers, providing
valuation services on any gift that happens to come up for evaluation. This is much
less fun than second-guessing taxpayers and the IRS.
BUT
IT WORKS FOR ESTATE TAX. Oddly enough, these "savings clauses" are
recognized by the IRS in computing estate tax. As TAM 200245053 itself points out, "...testamentary
marital deduction formula clauses pursuant to which the amount of the marital bequest (and
the amount of the marital deduction allowable under § 2056) fluctuates depending on the
value of the gross estate as finally determined for estate tax purposes, are widely used,
in order to take maximum advantage of the marital deduction and the unified credit
available..."
So
savings clauses work for estate tax, but not gift tax. Remember: it's the tax law;
it doesn't have to make sense.
Thirty percent
of the cost of business fixed assets purchased through September 10, 2003 can be expensed
in the year of purchase. If your business will be buying fixed assets soon,
accelerating the purchase to this year can qualify you for a substantial deduction.
The remaining 70% of the purchase price is depreciated under the usual rules; it may also
be eligible for the annual Sec. 179 deduction of $24,000 per taxpayer.
Remember,
the bonus depreciation is available only for new property. For new cars, bonus
depreciation is limited to $4,600 per car. Bonus depreciation is not
available for real estate.
DID YOU KNOW?
You can find property tax information from counties across the country on our web page? Visit the "links" page at www.rothcpa.com.
NOVEMBER 8, 2002
Yesterday we said the estate tax was "probably really, positively" dead as a
result of the Republican takeover of the Senate. We received a number (2 is a
number) of inquiries as to what exactly we meant.
Current law has the estate tax vanishing January 1, 2010. Current law also has
the estate tax reappearing in full force January 1, 2011. Under Senate rules,
60 votes would be needed to prevent the scheduled estate tax resurrection. It
appears likely that the 60-vote hurdle can be crossed with the new Senate
membership. We can assume the House of Representatives, with no 60-vote requirement,
will again vote for permanent estate tax repeal.
By one count, the
incoming Senate has 58 solid votes for repeal. Whether the Senate Democratic
leadership will be able to keep two more members from straying remains an open question.
BUT DON'T TEAR UP THAT ESTATE PLAN JUST YET.
For now, estate planning should be based on current law, but with the possibility of
repeal kept in mind.
NOVEMBER 7, 2002
REPUBLICAN SENATE: WHAT DO THEY MEAN BY THAT?
For the first time since Jim Jeffords made what now appears to be the 21st century's most
shortsighted party-switch, the Republicans control the Presidency and both houses of
Congress. We will ignore side issues like war and peace and our national future to discuss
what's really important: tax policy.
The change to a Republican Senate won't immediately lead to a massive change in the tax
structure. As a practical matter, 60 votes are needed to pass tax laws under Senate rules.
Drastic tax cuts, repeal of the corporate income tax, or the enactment of a national sales
tax do not seem to be in the cards in the next two years.
ESTATE TAX DIES, TAX CUTS LIVE. Still, the Republican Senate matters. Even with the
60-vote hurdle, the estate tax is probably really, positively, dead. It had been scheduled
to rise Zombie-like after a
one-year interment, but now it will not resurrect as scheduled on January 1, 2011. The
2001 estate tax repeal had significant Democratic support, and they will work with
the additional Republicans elected this week to cross the 60-vote hurdle. The
other 2001 tax cuts slated to disappear after 2010, including the reduction of the top
individual rate to 35%, also are likely to be made permanent.
A few specific tax rule changes can now be anticipated. A new "above-the-line"
charitable deduction for non-itemizers might be enacted yet this year. Significant reform
of the international tax rules can be expected early next year, triggered by the World
Trade Organization's ruling against the Extraterritorial Income Exclusion provisions.
There might even be an increase in the current $3,000 limit for annual capital loss
deductions for individuals.
REFORMS AHEAD? The biggest questions still open are whether we will see the overdue
reform of the Individual Alternative Minimum Tax (AMT) system, and whether the double
taxation of corporate dividends will be eased. As we have discussed, the
AMT will, unless changed, devour the broad voting and campaign-contributing classes
in a few years. These changes will "cost" the government a lot of money, so they
will have to be done in a way to get the 60 votes required for revenue-losers by Senate
rules.
Prior to the election, Republican leaders hinted that they planned to consider allowing
corporations to deduct dividends paid. This would also be a 60-vote issue, so the bruised
Senate Democrats will need to cooperate. That just might not be in the cards.
LAYING THE GROUNDWORK FOR MAJOR REFORM? With the change in control of the
Congressional agenda, we may even see a discussion about the real problems of our tax
system - its staggering complexity, high rates, and the perception of growing
evasion. OK, we like complexity and high rates -- we're tax professionals, after all
-- but it's hard to keep a straight face while making a public policy argument for
complexity. There is a (slim) chance that
the Republicans could use tax reform as their big issue for the next two years. One
can even dream that both parties will come together for a 1986-style tax code
housecleaning.
A SURE BET: Going out on a limb, we will predict that Senator Jeffords will a.) not chair the Senate Finance Committee, and b.) will be assigned a new Senatorial parking space somewhere near Arlington National Cemetery.
Iowa's race for Governor gives us no reason to expect a serious effort to
reform our horrendous state income tax. Tax reform played little part in the campaign, and
was almost ignored by the winning candidate.
Even so, it is hard to imagine that the issue can be neglected for another four years.
Iowa high rates and complex rules have helped the state lag behind its neighbors. Tax
reform may even be a hidden opportunity for Governor Vilsack. If he can devise and a
sensible tax structure with low rates and generous exemptions for low-income taxpayers,
and then work with the Republican legislature to get it passed, he might win the next
election by acclamation.
Bipartisan cooperation on good tax policy? When it happens, we will spread the news by
the state's high-tech network of flying pigs.
SEC. 529 EDUCATION PLANS - SAVING IN A BIG WAY.
Most taxpayers are content to save for college a little bit at a time. A donor can deduct
on their Iowa 1040s contributions of $2,180 per donee per year made to Iowa's Sec. 529
plan, College Savings Iowa. The income on
these plans build up tax-free, and the funds can be withdrawn tax-free to pay for college
costs.
Tuitions being as high as they are, some taxpayers find $2,180 inadequate.
The tax law permits these taxpayers to give more than that - even though the Iowa
deduction doesn't go any higher. If they exceed $11,000, however, they may be subject to
gift tax.
Here, too, the tax law comes through. Taxpayers can use up to five years
worth of annual exemptions to fund a Sec. 529 plan account.
EXAMPLE: Jenny Murphy wants to fund her daughter Heather's college education.
Jenny contributes $55,000 in 2002 to a College Savings Iowa account for Heather. Jenny
pays no gift tax, but uses up her annual gift tax exclusions for 2002 through 2006; any
additional gifts to Heather by Jenny through 2006 will either use up some of
Jenny's lifetime exclusion or cause Jenny to pay gift tax.
TAXPAYER OF THE YEAR NOMINEE
The Salvation Army has a long and
distinguished history of good works and service and a reputation as one of the best-run
charitable organizations in the world.
The Salvation Navy, on the other hand, has another sort of reputation entirely,
following its recent run-in with the Tax
Court. The "Navy" applied for tax-exempt status in 1999, with an
avowed charitable purpose to "find out where one goes when he or she
leaves." This purpose failed to pass muster with the IRS. The Navy then
said its goal was "to be an asset to the community and do good deeds."
Tax
Court Senior Judge Nims determined that the "Navy" was actually a man named
David Valfer, and that any income of the Navy really went to Mr. Valfer. While this might
seem to Mr. Valfer like a good deed, it wasn't good enough to convince the judge that the
"Navy" merited tax-exempt status.
Meanwhile, the Tax Update is looking into setting up a Salvation Coast Guard
Auxiliary. We will let you know when we, I mean the Auxiliary, can start taking donations.
DID
YOU KNOW?
You can visit the IRS and Iowa Department of Revenue and Finance via our
"links" page at www.rothcpa.com.
OCTOBER 30, 2002
We now have the ability to send e-mail formatted in HTML! We can now send you Tax Updates with clever links
to our favorite sites! We can use bold
or italic typefaces. We can even send
bold italic typefaces that are tacky
and garishly colored.
If the last paragraph had no bold italic tacky typefaces in garish colors,
your e-mail browser is not hip to HTML. If
you have difficulty reading the Tax Update in this format, let us know; we will make sure you continue to get a plain
text version.
Just in time for Halloween, the IRS says it is about to kick off its “National Research Project” (NRP). Translated from Newspeak, this means they are starting to audit a random sample of tax returns. The IRS will use the results from its audits to determine the best examination targets.
This program replaces the old Taxpayer Compliance Measurement Program (TCMP), generally known as “audits from Hell.” There will be about 50,000 examinations under the NRP. The NRP examinations (audits from Heck) are designed to be less invasive than the old TCMP audits, which required taxpayers to document every tax return item. The NRP will rely largely on W-2, K-1 and 1099 matching. Only 2000 returns are expected to get the full TCMP-type strip-search treatment.
Most practitioners approach the incorporation of a business in a pretty cavalier way. As long as the folks incorporating the assets end up with over 80% of the new entity, it seems hard to go wrong. Word processors in law firms all over the country stand ready to crank out the required documents.
A case like Seggerman Farms helps remind us why we approach incorporations as carefully as a rabid dog or an accountant on April 14. The Seggerman Family operated a cattle and grain farm near the central Illinois town of Minonk. At the request of creditors, the family incorporated the operation. Three family members contributed assets valued at $758,500, but with a tax basis of $127,201. The contributed assets were subject to liabilities of $639,925. The contributors remained liable as guarantors on the debt.
The IRS invoked Code Sec. 357(c), which treats the transfer of liabilities in excess of basis as a gain from the sale of the assets contributed. The taxpayer tried to convince the Tax Court that the continuing guarantee of the contributed liabilities got them off the hook. The Tax Court sided with the IRS. The Seventh Circuit Court of Appeals upheld the Tax Court.
THE NOTE SOLUTION. In two cases, taxpayers have avoided gain on the assumption of liabilities by contributing a personal note from themselves to the corporation. The Seggerman Farms courts distinguished those cases by saying that a guarantee is not the same as a note.
KEEP THE DEBT OUT OF THE CORPORATION. The two “note” cases have not been appealed outside of the Second Circuit, which covers parts of New England, or the Ninth Circuit, out west, so some practitioners prefer to avoid the issue by keeping the excess debt out of the new corporation entirely. The Seggerman Farms lenders who were so keen to see the business incorporated probably would understand that the $190,191 in additional federal taxes incurred by the Seggermans as a result of the incorporation did not enhance their creditworthiness. Securing the debt with the stock of the new corporation while keeping the debt out of the corporation itself would have avoided the problem.
THE LLC SOLUTION. Another way around the problem would be to place the assets in a Limited Liability Company (LLC), taxable partnership, rather than in a corporation. With proper drafting of the documents, the partners could have remained on the hook for tax purposes for their portion of the debt, avoiding gain recognition on the contribution. The LLC format would have probably achieved the creditor goals sought in the incorporation.
Roth IRAs are usually the best IRAs, when they are available. As discussed last week, they aren’t available to everyone. When they don’t let you use the Roth IRA, what other flavors are available?
Roth & Company, P.C. did not pay for naming rights for the Roth IRA; they were named after a Senator from Delaware. We certainly would approve of the government selling naming rights for tax breaks. We favor a stylish “Martha Stewart Capital Gain Enhancement Act (with matching throw covers).”
OCTOBER 22, 2002
No doubt many of you will join us today in setting aside a few moments of quiet contemplation to observe the 16th birthday of the Internal Revenue Code of 1986. Signed into law by President Reagan October 22, 1986, the Tax Reform Act of 1986 renamed the old 1954 Code and set the broad outlines for the tax law we know and curse today.
At its birth, the 1986 Code seemed overwhelming in its scope and complexity. Passive Loss Rules, Uniform Capitalization of Inventory Costs, Operating Loss Restrictions, and the current Alternative Minimum Tax Regime all joined the tax law that fateful day.
OH, FOR THE SIMPLE TIMES. Amazingly, the complicated regime of 1986 seems almost pastoral and quaint in its simplicity compared to today’s tax law. For all of its complexity, the 1986 Act was based on a remarkable achievement: it eliminated deductions, credits, gimmicks and preferences in exchange for a drastically lower rate. For all of its complexity, the 1986 Code came into being with a top individual tax rate of 28%.
CONTINUING “IMPROVEMENT.” An entire bookshelf groans under the changes Congress has made to the 1986 Code. Over a dozen major tax laws passed since 1986 have raised individual rates as high as 39.6%, added deduction phase-outs, and created three capital gain rates. Congress has enacted HOPE Credits, Lifetime Learning Credits, Indian Employment Tax Credits, Enhanced Oil Recovery Credits and New Markets Credits. We now have at least eight different education tax incentives. And every complication introduced has been praised as a bipartisan triumph.
SUCCESS! With all of this improvement, the tax law could hardly get any better. For practitioners, that is; we charge by the hour. The rest of the country has to cope with the looming imposition of the Alternative Minimum Tax on the entire middle class, the proliferation of shaky tax shelters marketed by major financial service and professional firms; the need for even the lowest income taxpayers to hire professional help to prepare their tax returns; and the sneaking suspicion that tax compliance is for saps.
WHAT NOW? The tax law could really use another clean-up, with an exchange of a broader tax base and an elimination of credits for much lower rates across the board. This seems about as likely as Trent Lott inviting Tom Daschle to Biloxi to discuss post-modern literature over cappuccino.
When the tax law gives us lemons, we must try to make lemonade. One way is to take advantage of the IRA tax benefits available under current law. Joint filers with an AGI of up to $150,000 can get the best deal, the “Roth” IRA. Contributions to a Roth IRA are non-deductible, but earnings accumulate tax free and can be withdrawn tax free at retirement. You can contribute up to $3,000 per year to a Roth IRA ($3,500 if you are 50 or older by the end of this year). The ability to contribute to a Roth IRA is phased out when AGI exceeds $150,000 for joint filers, or $95,000 for single taxpayers.
2003 PENSION AND PROFIT SHARING CONTRIBUTION AMOUNTS ARE OUT
The IRS has announced the limitations applicable to pension and profit-sharing plan contributions for 2003. Some key numbers are as follows:
Item |
2003
Limit |
401(k)
elective deferrals |
$12,000,
plus $2,000 additional for taxpayers 50 and over. (was $11,000 and $1,000) |
Deferral
available via a SIMPLE plan |
$8,000.
($7,000 for 2002) |
Amount
of compensation to be taken into account in computing profit-sharing contributions |
$200,000
(unchanged) |
IRA
contributions |
$3,000,
plus $ 500 additional for taxpayers 50 and over (unchanged). |
The IRS has issued the minimum rates to be charged for loans made in November 2002:
All historical AFRS are available on the “Links” page at www.rothcpa.com
DID YOU KNOW?
Iowa has a tax credit for taxpayers who add employees to their payroll if the taxpayer has a jobs training agreement with an Iowa community college.
OCTOBER 16, 2002
FAMILY LIMITED PARTNERSHIPS: HOW TO BLOW IT
Family Limited Partnerships (FLPs) have
become a very popular estate planning device - and with good reason. Many taxpayers have saved many thousands of
dollars of estate tax by contributing assets to FLPs.
2+2<4.
The key to FLPs tax benefits is the tax
law’s method of valuing them. The value
of an asset under the tax law is what a hypothetical buyer will pay a hypothetical seller
for the asset. When an asset is contributed
to an FLP, the asset – for example, a piece of real estate or a share of
publicly-traded stock - is transformed into an interest in the FLP holding the asset.
An outside buyer would weigh purchasing a limited partnership interest, which comes with no right to control or influence the general partner (say, the taxpayer's crazy uncle), against the alternative of buying real estate or stock directly. After giving due weight to these factors, the hypothetical buyer would only buy an FLP interest if it had a stiff discount to the underlying assets. This "marketability" and "lack-of-control" discount can reach 40% or more.
IS AGE 95 TOO SOON TO
START YOUR ESTATE PLANNING?
Every silver lining in the tax world has a
dark cloud. A recent Tax Court case shows how
carelessness and overreach can undo the benefits of an FLP.
No procrastinator, apparently, Theodore
Thompson tackled his estate planning in his 96th year.
He decided to provide for the future of his children with two new family
limited partnerships. He generously funded
them with about $1,400,000 each, receiving limited partnership interests in exchange. Two children each had a limited partnership
interest in one of the partnerships, and a corporation, in which Theodore had a minority
interest, held the general partner interests.
TOO MUCH OF A GOOD THING. The partnership contributions left Theodore with
few assets outside the partnerships, and he ran out of money in less than two years. He had to tap the partnerships for assets to make
his accustomed $10,000 annual gifts to his grandchildren and to pay his living expenses
for the 98th and final year of his life. The
partnership made no distributions to the other partners.
AN “IMPLIED” RETENTION OF CONTROL. The IRS convinced the Tax
Court that the operation of the partnership showed an "implied" agreement
that Theodore retained control over the partnership assets.
Under Sec. 2036(a) of the tax code, this "retained interest"
caused the assets in the partnership - rather than the partnership interest itself - to be
included in Theodore's taxable estate. One of
the key facts was the size of the partnership contribution; by retaining too few assets
for his own support, the court reasoned, Theodore showed that he really expected continue
to use the contributed assets.
WHAT DOES THIS TEACH US? FLPs remain useful and important estate planning tools, but they will only succeed when taxpayers “walk the talk” and operate the partnership as an actual enterprise, rather than a gimmick and cash hoard.
SOME DON’TS:
SOME DO’S
Like a long-slumbering giant waking to a herd of nimble elves looting his house, the IRS is sluggishly beginning to react to heavily-marketed tax shelter schemes. As the giant slowly wakens, the splattery thwack of his club on another elf is heard more and more.
Yesterday’s flattened elf was the PORC promotion industry (Notice 2002-70). This PORC has nothing to do with tasty bacon and everything to do with funneling money to tax havens. The PORC, or Producer-Owned Reinsurance Company, is a purported insurance company set up in a tax-haven country by, for example, an auto dealership.
The dealership will sell its customers insurance covering repair or replacement costs if the auto breaks down or is lost, stolen, or damaged, or coverage for the customer's payment obligations in case the customer dies, or becomes disabled or unemployed. The premiums paid by the customer go to three places:
While it doesn’t quite say so, the IRS apparently feels the “reinsurance” is really a kickback or disguised commission, rather than actual insurance. The tax benefit arises from the ability to stash cash in tax havens, as well as from obscure insurance tax rules such as the tax-exempt status of non-life companies with less than $350,000 in annual premium income.
ASKING AND TELLING. The IRS says PORC is spoiled for various reasons. Notice 2002-70 requires PORC lovers to disclose their affection under the anti-tax shelter rules; lack of disclosure will trigger fines and penalties. The IRS can also be expected to subpoena the customer lists of PORC promoters, causing severe indigestion to PORC consumers.
The stock market’s doldrums (ok, disasters) of recent months cause a problem for taxpayers who typically make year-end charitable gifts of appreciated stock. The problem is that there may not be much appreciation at the moment.
The tax breaks for charitable gifts of appreciated stock – fair market value deductions and no tax on the appreciation – also apply to other property held for over one year; they are just harder to get. For gifts of property other than public stock that exceed $5,000, the taxpayer has to get a qualified appraisal to verify the property, and the appraiser has to sign Form 8283 for inclusion with the donor’s tax return.
Your appraiser has to meet certain conditions. The appraiser cannot be related to you or to the person from whom you purchased the property, for example, and the appraisal fee cannot be based on the value of the property. Without an appraisal, no deduction is allowed when the claimed deduction exceeds $5,000.
Note that the appraisal requirement applies to all non-cash donations other than public stock; this is true even if the property is something easily valued, like a life insurance policy.
DID YOU KNOW?
Our web site now includes our “Pocket Guide to Iowa Bank Taxation.” Visit www.rothcpa.com and click your way there.
OCTOBER 11, 2002
THE (NOT REALLY) ALTERNATIVE MINIMUM TAX: COMING TO A RETURN NEAR YOU
We recently noted a peculiar feature of the tax law: while the tax brackets and standard deductions for the regular income tax are indexed for inflation, the alternative minimum tax (AMT) is not indexed.
The AMT is of course only an "alternative" for the taxpayer in the way keeping your wallet is really an "alternative” offered by the stickup man; taxpayers compute their tax under both the regular rules and the AMT rules and pay the higher tax. The top individual AMT rate is only 28%, compared to the top regular tax rate of 38.6%. While the AMT rate is lower, many regular tax deductions are not allowed for AMT – most importantly, the deduction for state and local taxes. The regular rate is slated to decline to 35% over the next few years, but no changes are in store for AMT.
Even without doing a lot of math, it is obvious that a tax that is not indexed for inflation will eventually become higher than an indexed tax, everything else being equal. With the scheduled decline in regular tax rates, “eventually” is sooner than you might think. In 1999, one million taxpayers paid AMT. According to the think tank Tax Policy Center, 36 million taxpayers will pay AMT by 2010 if the system isn’t changed. These proud 36 million will include 95% of all households with income between $150,000 and $500,000, according to the Center.
WHO PAYS AMT NOW? Inflation has yet to do its work on most taxpayers, but AMT returns are becoming more common every year. Certain sets of circumstances are most likely to produce AMT:
WHAT TO DO? Year-end tax planning is often the key to avoiding AMT. A projection of current-year taxes can enable your tax advisor to spot AMT coming, and maybe to take steps to avoid it. The best way to avoid AMT is often to pay state taxes in the same year the income is earned – even though the tax payments can legally be delayed well into the following year. In many cases taxpayers can control the timing income is earned to minimize AMT – or even, sometimes, to take advantage of the lower AMT rates.
