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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.
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.
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.
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...
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.
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.
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.
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.
First, you have to live until 2010 to take advantage of the repeal. We hope you
all do, but some of us will be taking our last deduction before then.
The repeal hasn't been made permanent yet. At least one very smart attorney has
offered to pay us cash if the estate tax repeal is made permanent; if it is not, the Tax
Update will abjectly admit to inept prognostication. (Naturally, we accept; the Osbourne family has nothing on us in terms
of accepting cash in exchange for public humiliation). If our pre-election forecasts
had been accurate, we wouldn't be talking
about this issue; for the next two years, Majority Leader Daschle would have permanent
repeal of the estate tax on the Senate calendar just behind funding for a manned space
mission to the Sun.
2010 is a long, long time from now in the
political world. Even if repeal is passed, President Hillary Clinton could be swept
into office in two years with Democratic majorities in both houses of Congress. If
that happens, the estate tax probably stays, even if the intervening Republican Congress
has enacted permanent repeal.
For now, estate planning should be based on current law, but with the possibility of
repeal kept in mind.
Families with over $1,000,000 in net worth should make sure their wills are in order to maximize
the $1,000,000 lifetime estate tax exemption.
If you have enough assets for the estate tax to be a concern, continue to take
advantage of the $11,000 annual gift tax exclusion by making annual gifts.
Consider using your lifetime exclusion during your life, if doing so is consistent
with your family and business needs. Anything you get out of your estate now is
immune from any future political shifts on the estate tax.
Continue to look at estate planning tools, such as Qualified Personal Residence
Trusts or Charitable Remainder Trusts, if they don't cost you current tax and are
consistent with your personal goals.
Avoid estate planning steps that require the payment of gift tax.
DID YOU KNOW?
We have added estate and gift tax tables to our "Links" page at www.rothcpa.com.
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.
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.
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.
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?
DEDUCTIBLE TRADITIONAL IRAs are seldom a choice for taxpayers
who cannot use Roths because the deductible Iowa income phaseouts kick in at lower income
levels.For married taxpayers, deductible
Roths start phasing out at $150,000.For
taxpayers who are participants in retirement plans, the 2002 deduction for traditional
IRAs phases out when income (technically, “Modified Adjusted Gross Income”)
exceeds $54,000.If the taxpayer and spouse
do not participate in a qualified plan, traditional IRA contributions are deductible at
any income level.
WHO PARTICIPATES IN A QUALIFIED PLAN?If you work for an employer with a qualified plan,
you are probably a participant.You are a
participant if you receive an allocation – even if you elect not to contribute a
401(k) plan.
SPOUSE BREAK: If your spouse is an IRA participant but you
are not, contributions to your IRA (but not the spouses) are deductible at higher income
levels; the phaseout begins at $150,000.
DON’T DISMISS NON-DEDUCTIBLE IRAs.Even if you don’t qualify for a Roth
IRA or a traditional IRA deduction, you can still make a non-deductible contribution to a
traditional IRA.The earnings in the IRA
accumulate tax-free until retirement. This
significantly improves the after-tax return on the investment, and it is a lot cheaper
than a variable annuity, which provides somewhat comparable tax advantages.
HOW MUCH CAN YOU CONTRIBUTE? For 2002, the lesser of your
“earned income” (Wages or business income, generally) or $3,000; you can add
another $500 if you are 50 years old by year-end.
DID
YOU KNOW?
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).”
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.
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.
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:
Don’t
impoverish your estate with your partnership gifts.
Don’t
routinely tap partnership assets for living expenses.
Don’t put
your house into an FLP, unless you sign a lease, pay rent, and observe all of the
formalities of ownership.
SOME DO’S
Do make sure to
re-title all FLP assets in the partnership name
Do make sure
distributions are not discriminatory to the donor
Do work with your
tax advisors to ensure that all formalities are observed and to help ensure the FLP is
respected for tax purposes.
Do only fund the
partnership with assets that you won’t be wanting back.
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:
A third-party
insurer that provides the actual insurance
The dealership, as
a commission
The PORC, as
“reinsurance” premiums on the policies issued by the third-party insurer.
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.
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:
TAXPAYERS WITH
LARGE CAPITAL GAINS.OK, this category is
only theoretical this year, but it could happen.The
top long-term capital gain rate is 20% for both regular tax and AMT.Think of the arithmetic here: a tax with few
deductions will be higher than a tax at the same rate with many deductions.This situation is especially true in
high-tax states like Iowa;
the state tax imposed on a big capital gain is non-deductible for AMT.
TAXPAYERS WITH
INCOME SPIKES.Taxpayers who follow a
high-income year with a lower-income year often get a nasty AMT surprise. If they wait until the due date of their return for
the high-income year to pay their state taxes, the deduction may wipe out their regular
tax entirely, without lowering the AMT computation at all.Owners of businesses operated as S corporations or partnerships (including limited
liability companies) often experience income fluctuations, with unpleasant AMT
results.
BIG LAWSUIT
WINNERS often share their awards with the IRS, which considers legal fees non-deductible
for AMT.
FORMER DOT-COM
MILLIONAIRES.The tax law has been even
crueler than the stock market to many of these unfortunates.Taxpayers who exercise “Incentive Stock
Options” (ISOs) must include in their AMT taxable income the exercise date
“spread” – the amount the stock value exceeds the option exercise price. Many options exercised with multi-million dollar
spreads in 2000 were worthless by the time taxes were due in April 2001. This has left many people in a hopeless tax
situation.
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.
BUT BE CAREFUL.The
AMT can, under some circumstances, generate an “AMT Credit” offsetting regular
tax in future years.This credit, while
welcome, can make AMT planning very complex; it can make the income acceleration strategy
very foolish at times.
Townsend Industries, Inc.,
an important Central Iowa manufacturer, has learned that no good deed goes unpunished by
the tax law.The company treats its sales
staff and employees to an annual fishing trip in Canada.Killjoys always, the IRS assessed payroll taxes to the company on the
grounds the fishing trips for 1996 should have been included in employee wages and
assessed payroll taxes to the company.
The company argued the trips were excludible from wages as
“working condition fringe benefits” under Code Sec. 132.The trial judge said that the company had to
demonstrate that the expenses were “ordinary and necessary” to qualify for the
Sec. 132 exclusion; to meet this standard, the company had to substantiate the expenses
under the strict standards that apply to travel and entertainment expenses.As the trial judge explained,
“In order to show the fishing trip expenses were directly
related to the active conduct of its business, Townsend needed to show at trial all of the
following: (i) it had ‘more than a general expectation of deriving some income or
other specific trade or business benefit’ from the fishing trips; (ii) that active
business discussions were conducted on the fishing trips; (iii) that the ‘principal
character or aspect’ of the fishing trips was the active conduct of business,
although it is not necessary that more time was devoted to business than to entertainment;
and (iv) the expenditure was allocable to Townsend's employees conduct of business and the
other people on the fishing trip with which business was conducted.”
TOO MUCH FUN?The
trial judge found that the company fell short of meeting these tests:
“The trip was not an integral part of Townsend
employees' ability to perform their jobs, it was not a part or a continuation of a sales
meeting, but rather was a relaxed and fun event where business was discussed as part of
the background to the primary fishing endeavor. Additionally, the testimony of Mr.
Townsend and Jorgensen made particularly clear at trial that Townsend basically held an
expectation to derive uncertain future benefits, particularly in the way of improved
comradery (sic) and relations among its employees and sales personnel, from the fishing
trip …such an expectation is not enough to allow the trips to qualify as directly
related under section 274(a).” (Citations omitted).
This case shows how difficult it can
be to have tax-favored fun.Without a
well-documented and somewhat regimented meeting schedule, the courts frown on out-of-town
employee outings.
COLD COMFORT: While ruling adversely
to the company, the judge provided an unusual testimonial at the end of his opinion:
“As this Court commented at trial, it has a deep respect
for the plaintiff company, its founder Mr. Townsend, and their business philosophy. The
company's success for over forty years dramatically reflects the legitimacy of the
"me too" business philosophy espoused by Mr. Townsend and his wife since the
company's inception. However, despite this Court's personal beliefs about the merits of
Townsend's methods, including the value of the fishing trip to the business, Townsend
simply is not exempt from the reach of the tax code and its regulations because it is an
exemplary employer who genuinely cares about its employees and community.”
He might have added: “It’s the tax law.It doesn’t have to make sense.”
So they might stay with it and get to
college.If you are considering using a Sec.
529 plan, the Iowa plan has special tax advantages to Iowa residents.Individuals can deduct contributions to College
Savings Iowa on their Iowa tax returns, up to $2,180 per child per year.To learn more, go to www.collegesavingsiowa.com.Earnings are tax-free if used to pay for college
education.Start budgeting now; contributions
must be made by December 31 to be deductible on 2002 returns.
DID YOU KNOW?
Updated auto mileage rates are
available on our Links page at www.rothcpa.com.
Change export tax laws to avoid $4 billion in trade sanctions?Hmm.We’ll
get back to you on that one.
If international trade laws had a “3 strikes and you’re
out” provision, Congress would be set to do some hard time.In January the World Trade Organization (WTO)
ruled for the fourth time that our tax law’s export incentives violate international
trading rules.The first three attempts to
comply were mere tweaks of the system; more, apparently, will be required.Absent compliance, our trading partners threaten
to impose punitive tariffs of $4 billion.The
sanctions would be rotated among different industries – from grain and livestock to
iron and steel -- presumably to annoy those affected into lobbying for repeal of the
offending incentives.
As practitioners and taxpayers, we take a more detached view of the
dispute.Rather than pondering the integrity
of the international trading system, we say: “Illegal export subsidies?Where can I get some of that?”
IT MAY BE AT YOUR FINGERTIPS.The
offending provisions are the “Extraterritorial Income Exclusion” (not to be
confused with the Extraterrestrial Income
Exclusion).This enables taxpayers to avoid
U.S. tax on up to 20% of income from export sales.For
taxpayers with over $5,000,000 in annual export sales, this exclusion is available as long
as certain activities take place outside the United States.For those of us with UNDER $5,000,000 in annual export sales, the exclusion
is there for the taking, for sales after September 30, 2000.
WHAT DO I HAVE TO DO? All that is required to take the exemption is
to claim it on Form 8873.If you have not yet
claimed it, you may be able to claim it on an amended return. To learn more, contact Joe
Kristan or Ken Boeke at Roth & Company, P.C. Remember – even though the exclusion
is illegal under international trading rules, it is perfectly legal on your tax return.Our legislators have taken this approach:
“Congress: we put the
“legal” in “illegal.”
BUT ACT NOW!These
incentives aren’t going to last.Well,
actually, they probably will last awhile.Yesterday
a “bipartisan working group” met to discuss a solution to the problem.Max Baucus (D-Idaho), the chief Senate tax writer,
said “This is not an attempt to delay… We did not discuss a specific solution,
but plan to have recommendations by the end of the year.”
Each year, Northern Illinois University Professor James C. Young
beats the IRS to the punch and computes the inflation adjustments to the individual tax
rates, standard deductions, personal exemptions and other items.To read them, go here.
One large area of the law that is NOT
adjusted for inflation is the individual alternative minimum tax (AMT).Now, if -
Regular
tax rates and exemptions are indexed, but
AMT
rates and exemptions are not, and
You
pay the higher of AMT or regular tax,
THEN
inflation will cause more people to pay AMT.
Interesting.More on this topic next week.
DID YOU KNOW?
We have added county property tax
information to our “Links” page at www.rothcpa.com.You may find assessment and payment information
for properties in Polk, Warren and Dallas counties in Iowa.We plan to add more counties soon.
Introspection has struck the Internal Revenue Service.In light of the proliferation of corporate tax
shelters, the popularity of offshore credit cards, and the discovery of new schemes in the
tax shelter amnesty program, the IRS has looked into its soul and found its priorities
wanting.IRS Fact Sheet FS 2002-12
announces:
“The Internal Revenue Service is realigning its audit
resources to focus on key areas of non-compliance with the tax laws.”
Um, OK.It’s good they aren’t planning to
concentrate on unimportant areas of non-compliance with the tax laws.
“The strategy represents a
new direction for the agency’s compliance efforts.”
So they HAVE been focused on non-key
areas of non-compliance?
“The initiative will feature new and enhanced
efforts on several priority areas, including
·Offshore credit card users.
·High-risk, high-income taxpayers.
·Abusive schemes and promoter
investigations.
·High-income non-filers.
·Unreported income…”
These are NEW areas of focus?“Abusive schemes” have been secondary
priorities for tax law enforcement?“High-income
non-filers” have been unworthy of sustained attention?
What HAVE they been looking at?Perhaps the IRS is downgrading the following
priorities:
·Incorrect rounding – rounding up
or down, instead of to the nearest whole dollar.
·Misspelling of corporate stock names on
dividend and capital gain schedules.
·Failure to check “yes” or
“no” on the presidential campaign fund box.
·Failure to use a nine-digit zip code
when mailing tax returns.
Many small businesses and
self-employed taxpayers wait until the last quarter to start their year-end planning.Unfortunately, one arrow is no longer in the tax
planning quiver by then: the “SIMPLE IRA” retirement plan.While most plans can be set up anytime before the
end of the year, SIMPLE IRA plans must take effect by October 1 to apply to the current
year.
HOW THEY WORK: SIMPLE IRA plans
function somewhat like 401(k) plans.Employees
designate an amount to be taken out of pay tax-free; this amount is contributed to an IRA
for the employee designated“SIMPLE
IRA.”Employees may defer up to $6,500
of compensation annually ($7,000 if they reach age 50 by year-end).The employer is generally required to match the
contribution dollar-for-dollar, up to 3% of the employee’s compensation.Alternatively, employers can contribute up to 2%
of compensation for all-employees on a non-match basis.
WHY THEY CAN BE ATTRACTIVE:They are, well, simple.They can be established by completing a short IRS
form.Form 5304-SIMPLE sets up a plan where
employees select their own IRA custodians; Form 5305 is used if all contributions are to
be made to a SIMPLE-IRA “designated financial institution” selected by the
company.Once contributions are made, the
employer’s involvement is over.No
annual Form 5500s are required, and the employer doesn’t have to select mutual funds
for the employees to choose from.They are
relatively easy and cheap to maintain.
WHY THEY AREN’T MORE POPULAR:
Self-employed taxpayers often can make larger contributions to old-fashioned SEP-IRAs.The contribution limits for employees are larger
under traditional 401(k) plans.They cannot
be combined with traditional profit-sharing plans, so they preclude popular plan features
that funnel benefits to owners.
WHO CAN USE THESE: SIMPLE IRA plans
may be set up by businesses with no more than 100 employees earning over $5,000.
The IRS has announced (IR-2002-97)
that Honda Insights for
model years 2001, 2002 and 2003, and hybrid-fuel Honda Civics
for model year 2003, qualify for the hybrid fuel vehicle deduction.This deduction, worth up to $2,000, is available
for the year the vehicle was placed in service.Taxpayers
who already have such a car may file amended returns to claim their deduction.This is an “above the line” deduction,
available whether or not you itemize.
The IRS earlier announced that the
Toyota Prius hybrid fuel car
qualifies for the deduction.
The IRS has set mileage rates for
2003 (Rev. Proc. 2002-61):
The
standard mileage rate for the use of a car for business purposes is 36 cents a mile for
all business miles driven, down from 36.5 cents a mile in 2002.
The
standard mileage rate for the use of a car when giving services to a charitable
organization remains at 14 cents a mile.
The
standard mileage rate for the use of a car for medical reasons is 12 cents a mile, down
from 13 cents a mile in 2002.
The
standard mileage rate to use when computing deductible moving expenses is 12 cents a mile,
down from 13 cents a mile in 2002.
The IRS
has issued the minimum rates to be charged for loans made in October 2002:
Short Term (demand
loans and loans with terms of 1-3 years): 2.03%
Mid-Term (loans
from 3-9 years): 3.46%
Long-Term (over 9
years): 4.9%
All historical AFRS are available on the “Links” page at www.rothcpa.com
DID YOU KNOW?
The Roth & Company Pocket Guide
to Iowa Bank Taxation is now online?
It is a layman's map through the arcane world of Iowa bank taxation. It also
includes handy tax-equivalent yield tables for exempt income of Iowa banks. It's
nowhere on the net but www.rothcpa.com! Paper
copies are also available; send your request to kmortenson@rothcpa.com.
We have been sending the Tax Update for about 10 months now.It is time to answer the pressing questions that
are certainly on your mind with this “FAQ” (Frequently Asked Questions) edition
of Tax Update.
ARE YOU FREQUENTLY ASKED QUESTIONS?
Next question.
WHAT IS YOUR PUBLICATION SCHEDULE?
We try to publish once a week or so.If something is urgent, we try to get the word out right away.Sometimes we will miss a week, which makes us feel
bad.
WHO WRITES THIS STUFF?
There are too many contributors to name in a brief space.Much of the legwork is done by a team of 535
full-time comedy writers located in Washington D.C.Additional
contributions come from the other two branches of government, from state governments and
from eager taxpayers everywhere.Joe Kristan
compiles the best of the contributions, with assistance from an elite team of Roth &
Company, P.C. professionals who carefully screen out technical errors, poor taste, irony,
sarcasm and humor.
WHY ARE THE LINKS ON THE E-MAIL EDITION SO LAME-LOOKING?
Our current e-mail software does not allow us to format hyperlinks
the way you see them on web pages – so we cannot have you simply click on a word to
follow a link.We have to spell out the whole
Internet address, or URL, which makes it much harder to be cute and clever.Bob, our computer guy, promises that our impending
software upgrade will provide full hyperlinking capability to our e-mail edition.To urge Bob to speed up the upgrade, send an
email via this lame-looking link: bhickok@rothcpa.com.
They are another helpful service to our friends and clients.It is easy to forget to file a return or an
estimate.If we can help one taxpayer avoid
the heartbreak of late filing, we will be good-deed doers.
If you would prefer not to not receive the due-date reminders, we
will take you off the list.Send an email to news@rothcpa.com with the heading “news only”
I DON’T WANT TO RECEIVE ANY OF YOUR STUFF.
Then send an email to news@rothcpa.com
with the heading “unsubscribe.”We
will remove you from all of our email lists.
CAN I INFLICT, ER, SHARE YOUR EMAIL WITH MY FRIENDS?
Of course!Send us their
email addresses and we will start sending them Tax Updates and due date reminders.Again, news@rothcpa.com
.
CAN I FIND OLD TAX UPDATES ON YOUR WEB SITE SOMEWHERE?
We love tax breaks.We
love convoluted tax planning schemes.We
love our legislators.
As tax practitioners, what we love most is charging for our time.Every tax break for a preferred constituency makes
the tax law that much more complicated and makes it harder to lower tax rates.Complexity and high rates increase the need for
our services, and our revenue.
Our selfish interest of course conflicts with the interests of
taxpayers, who would fare best under a system of low rates, no special breaks for good
causes, and simple rules.The heck with that!
We want more tax credits, more exclusions, and longer forms!Lacking other marketable business or social
skills, it’s all we have.
Seriously – with Iowa’s complicated tax structure and very
high corporate rates (12%!), special tax breaks are a natural response to cope with a
horrific system.If the system were not so
horrific, the breaks would be unnecessary.South
Dakota has no special income tax breaks – but it has no income tax.It seems unlikely that a steep income tax with
generous tax breaks would improve the South Dakota business environment.
Send an email with your insights to news@rothcpa.com.If (in our sole judgment) your comments are
suitable for family reading, we will with your approval post your comments on the web site
and link to them from the Tax Update
Advances in technology may someday allow readers to post comments
directly on our website.
SPEAKING OF YOUR WEBSITE, DO YOU KNOW THAT IT LOOKS LIKE IT WAS
DESIGNED BY A GRAPHICALLY-CHALLENGED ACCOUNTANT?
An exciting redesign is in the works.Stay tuned, and let us know if there are any features or links we should
add.
They're baaaaack!Congress
has returned to work for its last round of business before the election.With control of each house up for grabs, all
tax debate will be intensely political.Posturing
for votes takes priority over getting any legislation passed.Under these circumstances, it seems unlikely that
much actual legislation will occur.
The President is likely to propose investor-friendly tax proposals.These may include
-an
increase in the amount of net capital losses that can be deducted by individuals; the
current limit is $3,000 per year.
-a
corporate deduction for dividends paid, or an individual deduction for dividends received.
The $3,000 limit on capital losses is long overdue for an increase,
if only to reflect inflation.Some version of
this might pass, if only because so many constituents have an unwelcome opportunity to use
such losses.
A DEDUCTION FOR DIVIDENDS PAID is much less likely to pass.A pity.It
is difficult to find a tax policy reason C corporation income should be taxed twice –
first when earned, and again when paid as dividends.From a policy perspective, the ability to deduct interest payments, but not
dividend payments, is an incentive to finance a business with debt, rather than equity.This is, of course, a recipe for thin
capitalization.
Double taxation, combined with the lower tax rate for capital gains,
provides an incentive for shareholders to leave earnings in the control of management, in
hopes that it will enable them to increase stock value that can be cashed in at capital
gains rates.They’ve done a heck of a
job lately, haven’t they?Everyone I
know sleeps better at night knowing Microsoft sits on $40 billion in cash.
THERE ARE OPERATING CORPORATIONS THAT DO GET TO DEDUCT DIVIDENDS
PAID. Real Estate Investment Trusts are not only allowed to deduct their dividends, they
are required to pay out almost all of their taxable income as dividends.Perhaps not coincidentally, REITs have been the stars of the bear market, so
far.When faith in public company
financial information is shaky, nothing inspires confidence in reported earnings more than
receiving them in cash.
THE SECRET CABAL OF TAX PREPARERS that apparently controls Congress
(how else can we explain the tax law?) is likely to thwart any dividend relief, under the
guise of fiscal responsibility and equity for lower-income taxpayers.This will enable us to continue to reap fees by
setting up otherwise irrational tax schemes to avoid double taxation.Heh.Heh.
Bwa-ha-ha!
The 2001 Tax Act came to the aid of baby boomers who have been
procrastinating on their retirement savings.Congress
permitted taxpayers who are 50 or older by 12/31/02 to make extra contributions to their
IRAs and 401(k)s.As always, the younger
siblings will have to wait.The contribution
limits for 2002:
In 2001, the IRS paid $293,911 to move a middle manager from Los
Angeles to San Diego.I realize freeway
traffic can be tough, but for that kind of money you should be able to move an agent to
the overseas location of your choice.
DID YOU KNOW?
You can get a credit on your Iowa tax return for football cleats
purchased for your high-school athletes?School
band instrument rentals qualify, too.These
expenses qualify for the 25% tuition and textbook credit on up to $1,000 of expenses on
Form IA 1040X.For a more complete list of
qualifying expenses, click here.
From the August 27 issue of Tax Notes Today come statements unlikely
to be used by the executive recruiter trying to hire the next IRS Commissioner:
Anyone who has served as IRS commissioner
knows what it's like to be "at the vortex of the sewer of the world," according
to former IRS Commissioner Sheldon S. Cohen, whose tenure was arguably less tumultuous
than the ones served by some of the other living former commissioners.
"It's kinda like coming in from a nice fall day into a
blast furnace," said current IRS Commissioner Charles O. Rossotti, describing his
entrance onto the national tax stage after a quarter-century in the private sector.
It’s news to us that there is a “sewer of the world,” and that it has a
vortex.It’s a relief that the sewer
vortex is at IRS Headquarters, 1111 Constitution Avenue, Washington D.C. (it doesn’t
smell as bad as you might expect), rather than in Iowa somewhere.It’s hard enough to draw tourists.
Our last Tax Update described the sad fates of a number of tax
planning ideas – ok, we called them schemes – based on life insurance products.While it is important not to get burned by dubious
life insurance products, it is also important to use life insurance where it can provide
real tax savings and financial advantages.
LIFE INSURANCE DOES HAVE REAL ADVANTAGES under the tax law.The investment buildup in life insurance is not
subject to income tax unless the policy is surrendered before death.Investment build-up in a policy may be borrowed
tax-free.Policy ownership can usually be
structured to keep life insurance proceeds out of a taxable estate.Finally, policy proceeds at death are tax-free.These tax advantages can be very useful in tax and
estate planning.
FUNDING ESTATE TAX is one of the most important uses of life
insurance.Many estates are illiquid, with
most of their value tied up in real estate or interests in closely-held businesses.A life insurance trust can provide the means to
pay the estate tax without forcing a fire-sale of the illiquid assets.The trust can use the proceeds of life
insurance to pay the estate tax (for example, via a loan to the estate).The trust is “owned” for estate tax
purposes by the successor generation, so the life insurance proceeds are not themselves
subject to estate tax.
SECOND-TO-DIE policies are often the most cost-effective form of life
insurance in a life insurance trust.Most
taxable estates only pay estate tax at the death of the surviving spouse.The actuarial odds on two lives are better than on
one, so the premiums on second-to-die policies are more affordable than on a given single
life.
DEFERRED COMPENSATION PLANS are often funded by life insurance.The cash-value build-up on an insurance policy is
often used to fund a deferred compensation arrangement.While the policy is subject to claims of general creditors, it can be a way
to assure an executive that the deferred compensation won’t necessarily be deferred
forever. Similar results can be achieved by having the employer pay policy premiums on an
employee-owned policy – an “executive bonus” plan.
DEATH RISK is the most important reason to secure life
insurance.Individuals need to make sure that
their families are provided for in the event of an untimely departure.Businesses need to consider “key person”
life insurance to cover the costs of a sudden loss of a key player in the business.
BUY-SELL AGREEMENTS of closely-held businesses are often funded with
life insurance to provide liquidity for a stock buyout on the death of a large
shareholder.
GOOD INSURANCE is acquired for business reasons at a reasonable cost
from a major provider in good financial condition through a familiar, knowledgeable and
trustworthy broker.If you don’t need
permanent coverage or the internal “investment” build-up of life insurance,
economical term insurance is good insurance.
BAD INSURANCE is acquired primarily for non-business tax reasons,
typically from a company you never heard of, often at an inflated cost, as a result of a
solicitation from a broker with whom you have never worked.
To paraphrase Steve Martin, first you get your house to go up in
value by $500,000.Then you have to meet a
few other simple requirements:
-The house has to be owned and used as your principal residence for
at least 2 of the previous 5 years.
-You cannot have excluded gain from the sale of another principal
residence in the prior two years.
The maximum exclusion is $500,000 for married taxpayers filing a
joint return and $250,000 for single taxpayers.
Under normal circumstances the 2-year rules are all-or-nothing.If you closed your sale 23 ½ months after you
moved in, you could not exclude any of the gain; two weeks later you could exclude it all
(up to the $500,000/$250,000 limit).Relief
from this strict rule is available if the sale is due to certain unforeseeable
circumstances – a health crisis, or a job change, for example.If the relief provision applies, $500,000/$250,000
amounts are pro-rated; a joint return could exclude up to $250,000 for a house owned and
lived in for 12 months.The IRS last week (Notice 2002-60) said moves
resulting from the death of a spouse, a man-made disaster, or an act of war also qualify
for this relief. Sales caused by the September 11 attacks are specifically covered.
The law no longer requires taxpayers to “roll” their home
sale proceeds into a new house.There is no
minimum age requirement for the exclusion.
DID YOU KNOW?
Taxpayers with jobs training agreements with Iowa community colleges
can qualify for valuable state income tax benefits? We
have added the Des Moines Area Community College jobs training program to our
“links” page at www.rothcpa.com.
The IRS has issued new final regulations on “self-charged”
items under the passive loss rules.The new
regulations inflict tax pain on many taxpayers with passive activities, but they provide
limited relief for some.
A “self-charged” item occurs when a taxpayer has a
transaction with an entity that she owns which generates passive losses.For example, if a taxpayer loans money to an S
corporation which generates passive activity losses for her, the interest income received
would normally be non-passive, but the interest expense paid by the S corporation would
pass to her tax return as a passive loss on her K-1.Such “self-charged” interest is allowed to be offset against the
passive loss caused by the interest deduction.
The new rules allow taxpayers with two identically-owned pass-through
entities to use the self-charged rules.If
the taxpayer owns 100% of two S corporations, interest paid by one to the other could be
treated as “self-charged.” If the ownership is not identical, however – if
even 1% of one of the S corporations is held by her son – the interest is not treated
as self-charged; the interest income is 99% offset by the interest expense economically,
but not at all on the tax return.
Eddie Haskell figured prominently in the old “Leave it to
Beaver” show as an oily character who took advantage of adult cluelessness to charm
his way out of trouble.Several recent cases
and IRS rulings illustrate some of the shortcomings of the Eddie Haskell approach to tax
problems.These examples show that while the
IRS may do stupid things, it is not required to be stupid as a matter of law.
The lack of required stupidity is bad news for taxpayers who have
used certain heavily marketed tax sheltering techniques.The techniques are varied, but they have two things in common:
They require the
IRS to accept an illogical (but taxpayer-friendly) result from a skein of plausible, but
shaky, premises.Stated bluntly, they
require the IRS to be stupid.
They require life
insurance.
JANITOR INSURANCE: The holding company for now-defunct Camelot Music
took out whole life policies on 1,430 employees in 1990.The policy was set up to take advantage of the tax-free build-up of values
in whole life policies.Premiums of about
$14,000,000 per year were funded with policy loans, withdrawals and dividends of about
$13,000,000.
Disregarding tax deductions, the plan generated a loss each year.This would achieve a lucrative after-tax
irrational result: interest deductions with no net economic outlay.By offsetting tax-free policy build-up against
nearly-identical interest payments, the arrangement became profitable after taxes.
The court ruled
that the tax law didn’t have to stupidly pretend that the offsetting expenses had
economic reality just because actual checks were used to make the offsetting payments.The court disallowed the deductions and imposed
20% penalties for understating taxable income.
DOCTOR INSURANCE: In Neonatology Associates, life
insurance sellers persuaded a doctor group to join a Voluntary Employees Beneficiary
Association (VEBA) in order to achieve life insurance miracles.VEBAs were originally designed as a tax-exempt
vehicle to hold deductible pre-payments of employee benefits.Because VEBA contributions used to purchase term
life coverage can be deductible, insurance agents look for creative ways to use VEBAs.
The Neonatology VEBA was used to buy very expensive term coverage.The term policies were outrageously expensive
(500% over the normal cost of similar policies) because the overpriced amount was treated
as “conversion credits,” convertible into Universal Life policies that could be
almost fully withdrawn as tax-free policy loans.The scheme sought the irrational result of tax deductible VEBA
contributions that could be withdrawn as tax-free policy loans.
The third circuit ruled that the IRS was not required to be stupid
and pretend that the VEBA contributions really were buying overpriced group-term coverage,
rather than disguised universal life coverage.No
deduction for the excess contributions were allowed, and the doctors were taxed on the
excess as dividends.To show that the IRS
should not be assumed stupid, the court also imposed negligence penalties.
OVERPRICED OR PREPAID SPLIT-DOLLAR LIFE INSURANCE has been marketed
as an estate planning panacea.Under this
type of plan taxpayers establish a life insurance trust with the donor’s children as
beneficiaries.The trust buys a very large
(or very expensive) life insurance policy.The
insurance policy proceeds received by the trust are excluded from the donor’s taxable
estate.The policy is typically funded with
large prepayments or very expensive premium rates, all paid by the donor establishing the
policy.
The irrational result claimed by promoters of this setup is that the
amount subject to gift or estate tax is much less than value of the benefit passed to the
next generation.In some versions, the policy
premiums are purposely overpriced -- by as much as tenfold.The value used to value the gift to the younger generation is the lowest
premium cost available for a similar policy, or in some variants, a term life premium from
an IRS table.The “excess” amount
of the price increases the policy’s cash value in favor of the next generation.Such a scheme got front page treatment in the New York Times(the Times requires you to register to see
the linked article).
The IRS last week said it would decline to be stupid in this area.Notice 2002-59 states that the cost of the cost of
the bargain-priced policy, or the bargain costs from IRS tables, are not -- and never were
-- the appropriate measure of the taxable gift to the successor generation.The Times reports that some families have
paid as much as $40,000,000 in premiums under such schemes, so there will be some
interesting discussions between promoters of these plans and their clients.
What’s more, the Treasury made clear in their announcement that
they will attack all schemes where the actual benefit of a policy payment for income or
gift tax purposes is understated by the use of published premium tables or overpriced
policy premiums.
ARE THE INSURANCE PROMOTERS OUT OF BUSINESS?Not likely.As
long as bears variable annuity in the woods, there will be folks looking for new and
creative ways to unlock your inner commission-generating potential.
Mining has a rich and
storied history in Iowa.Iowa coal heated
homes and fueled locomotives for many years.Iowa
stone built many of our classic 19th century buildings, and Iowa quarries are enjoying
something of a revival now.Fort Dodge is an
important producer of high-quality gypsum.Iron
was mined near Waukon early in the 20th century.
Technological advances have opened up an important new mining resource
for the State.The Iowa Department of Revenue
and Finance has tapped the rich veins of data that can be found statewide, but are
especially bountiful around the Hoover state office building.
"Data Mining" is the process of using computers to sort
through state records to identify businesses that ought to be filing Iowa tax returns.Since investing in a $11.5 million NCR data mining
program in May 2000, Iowa has recovered about $18.8 million in back taxes, according to
Rhonda Kirkpatrick, a specialist at the Iowa Department of Revenue and Finance.
HOW IT
WORKS: The data mining system collects digital debris businesses unwittingly leave
behind as they operate in the state.Vehicle
registrations, property tax payments, and purchase orders of state agencies accumulate
over the years in state records.The state
also mines data provided by the IRS.Like
geologists deciphering long-extinct worlds using traces of critters left behind on ancient
sea floors, the data miners identify potentially lucrative non-filing taxpayers by their
traces in fossil data beds.
WHO
GETS CAUGHT? The data miners say there is no stereotypical non-filing taxpayer.“We’ve identified small businesses.We’ve identified large businesses,” says
Ms. Kirkpatrick.She says the small
businesses tend to quickly come to terms with the Department; the large ones “are the
ones that take a little bit longer.”
Many of these taxpayers don’t know their activities are taxable
in Iowa; for these taxpayers, data mining is the start of an “educational
process,” according to Ms. Kirkpatrick.
WHY
DO I CARE?As taxpayers from
out-of-state cast few votes in Iowa, they are a coveted source of additional tax revenue.Other states are using similar techniques to
identify non-filers.As businesses expand
into new states and add services in old ones, they should review their state activities
and filings with their tax advisors every year.It
is especially important to consider the tax issues before jumping into a new state. Every
year it becomes less likely that activities in a new state will escape the notice of the
taxing authorities.
IF
I'M PAYING IOWA INCOME TAXES, I'M HOME FREE, RIGHT?Not
necessarily.The data mining has identified a
number of Iowa taxpayers who owe “use taxes” on purchases from
out-of-state vendors that would be subject to sales tax if purchased from Iowa vendors.
With proper planning, state tax expenses can usually be kept
manageable.Without planning, state tax
bills can become painfully large – especially if they are ignored for years.For example, Iowa’s data miners recently
received a $3.8 million payment from a single out-of-state taxpayer.The statute of limitations usually only begins to
run once the state tax return is filed, so time doesn’t necessarily solve problems
for non-filers.Data mining provides one more
reason for taxpayers to review their state tax picture.
The IRS announced yesterday that it had stopped sending
“matching” notices to recipients of K-1s from partnerships, trusts and S
corporations.The 65,000 notices already sent
are still valid and must be answered.
The IRS stopped sending notices after complaints, including one from
Missouri Senator Bond.The complaints arose
because some taxpayers apparently report their K-1 income due to “netting of gains
and losses,” according to a report in Tax Notes.This makes it appear that many individuals report their K-1 items
“net,” despite Form 1040 instructions requiring K-1 information to be reported
in an itemized format on most tax return schedules.This
improper reporting means there is no detail for the IRS to match to K-1 items.
The IRS earlier this summer started the matching program on returns
filed in 2000 (see our report in the
July 5 Tax Update).Over $1 trillion of
income was reported on K-1s in 2000, according to the IRS.The IRS is to issue a report on the matching program this fall.
Your ship has come in!The
IRS has certified the Toyota Prius as eligible for a $2000 tax deduction for model years
2001, 2002 and 2003.This deduction must be
taken in the year the vehicle is first used, so an amended return may be in order.There is no requirement that the car be used in a
business to take this “clean fuel vehicle” deduction.The deduction is taken “above the line,”
so it is available to itemizers and non-itemizers alike.
Small businesses can find out about Iowa taxes, small business
development programs and more at the Iowa Small Business Development Center Site.Find it on the www.rothcpa.com
“links” page, or click here.
Entrepreneurs often set up a new S corporation every time they set up
a new business.The attorney gets to fill out
a new set of corporate organization documents, the accountant gets to do a new tax return,
and the client gets to isolate each business from the potential lawsuits of each other
business.The whole team wins!
Unless, of course, one of these businesses loses money.S corporation shareholders can only deduct losses
to the extent of their basis in the S corporation stock, plus their basis in any direct
loans made to the S corporation.(S
corporations do not pay taxes on their earnings; their shareholders instead report the
income or loss on their individual 1040s.To
learn more about S corporations, click here.)This basis is reduced by taxable losses; when an S
corporation is thinly capitalized, basis can disappear quickly.
GAMES PEOPLE PLAY. Sometimes taxpayers only find out that they are
out of basis at tax time.If they are
counting on their S corporation losses to reduce their taxes, they can get very upset.They can also get imaginative.They may imagine, for example, that they borrowed
money from their profitable S corporations before year-end and loaned it back to the loss
corporation.They then prepare their tax
returns deducting losses against their imaginary basis. The technical name for this
technique is “fraud.”
Wiser taxpayers arrange for sufficient basis before year-end.Donald G. Oren, a Minnesota trucking company
entrepreneur, recently
learned the hard way how difficult this can be to accomplish.Shortly before the end of the tax year, the
shareholder borrowed money from his profitable S corporation, Dart Transit Co., and loaned
it to his loss S corporation, Highway Leasing.The
loss corporation then promptly loaned the funds directly back to the profitable S
corporation – closing the circle and getting the cash right back where it started.
SO WHAT’S THE PROBLEM?The
taxpayer did everything the right way in executing the transactions. He had checks
written, rather than simply making bookkeeping entries.He had notes executed, and he completed all of the transfers before
year-end.The Tax Court said this wasn’t
enough.The court said that the circle of
money and loans – from the profitable corporation to the taxpayer to the loss
corporation and back to the profitable corporation – had no substance. And even if
there was substance, said the court, the loan wasn’t “at-risk,” so it would
not be available to allow a loss deduction.
WHAT DOES THIS CASE TELL US? Taxpayers with multiple controlled S
corporations need to be very careful how they get basis for losses.In many cases, the best solution is to put
controlled S corporations into a single S corporation holding company – an option
that was unavailable in the tax years covered in this case.Such a holding company structure can be treated
as a single S corporation with a single basis, avoiding the need to move funds around when
one corporation has losses.This idea also
works using LLCs; in both cases, each business is protected from liabilities of the
others.
Where a common holding company structure is impractical, taxpayers
should first use funds from their personal resources to fund S corporation losses.If they must use funds from other S corporations,
they should consider having the profitable corporation make distributions to the
shareholders, rather than loans; distributions of S corporation earnings are generally
tax-free.The shareholders should consider
contributing funds to the loss corporation as capital, rather than as debt.The loss corporation should refrain from loaning
the injected funds back to the profitable corporation.
IS THIS THE LAST WORD?Mr.
Oren will owe nearly $5,300,000 in additional federal taxes and an unknown amount of state
taxes if this case is not reversed on appeal.An
appeal seems likely.
An appeals court has upheld the IRS in striking down the use of a
VEBA (Voluntary Employee Beneficiary Association) to provide tax-free benefits to highly
compensated executives.The case (Neonatology
Associates, PA, CA-3, #01-2862, 7/29/02) involves a setup where a professional medical
corporation attempted to deduct contributions to a VEBA to buy life insurance.The contributions were far in excess of the cost
of coverage, creating cash reserves that the doctors could purportedly withdraw tax-free.
The appeals court sustained the Tax Court ruling that the
doctors’ corporation could only deduct payments up to the cost of term life coverage.The cost of term coverage was a small fraction of
the amount contributed.The approximately
$1,000,000 in excess of the cost of term insurance was treated as dividends --
non-deductible to the corporation, but taxable to the doctors.The doctors were also hit with penalties; the
court ruled that the doctors could not reasonably rely on tax representations made by the
insurance sellers who promoted the plan.
We hope to discuss this case more in a future Tax Update.In the meantime, approach VEBA life insurance
schemes with the same respect you would give to wealth-generation opportunities on
unsolicited faxes from Nigeria.
Many of us lately find ourselves holding shares of stock that are
worth, well, somewhat less than what we paid for them.In some cases, the only value remaining in our investment is our potential
tax deduction.Perhaps we may use our losses
to avoid paying tax on the massive gains we recognized when we bailed out of our WorldCom
shares last January.
A loss on a sale of stock is a capital loss.Such losses are fully deductible to the extent of
capital gains; individuals can deduct an additional $3,000 per year.Individuals can carry unused capital losses
forward indefinitely.Corporations can carry
such losses back three years and forward five years.
The “wash sale” rules disallow losses if the same stock is
bought within 30 days before OR after the loss sale.If you think, for example, that WorldCom is a screaming buy today, but you
would like to deduct your losses on the WorldCom stock you sold yesterday, make sure 30
days have passed before you buy more WorldCom shares.
For most stock positions, the “trade date” is the effective
date of a stock sale for tax purposes.For
“short” positions sold at a loss, however, the “settlement” date is
the effective date.At this point, the
problem of losses on short positions is only theoretical, as they can only occur if a
stock price rises.
Certain fringe benefit plans are no longer required to file Form 5500
as a result of a recent IRS notice.The
Notice (Notice 2002-24) eliminates the Form 5500 filing requirement for small cafeteria
plans, dependent care plans and adoption assistance plans.The notice is effective for any returns not yet filed, including overdue
returns.
Educational
assistance plans with fewer than 100 participants
Other unfunded
“welfare benefit plans” with fewer than 100 participants that are either (1)
fully-insured; (2) payable out of general employee assets or employee contributions; (3) a
combination of (1) and (2).
Welfare benefit plans are those providing (whether or not using
insurance) medical benefits, accident or death benefits, vacation benefits, employee
apprenticeship and training programs, group legal plans and day-care services.The most common welfare benefit, of course, is
health coverage.
Form 5500 is still required of many plans.For example, pension and profit sharing plans,
including 401(k) plans, have to file Form 5500.So
do health plans and other welfare plans, if they cover more than 100 participants.They are generally due on the last day of the
seventh month after the end of the plan year.If
the plan and the plan sponsor have the same plan year, the plan return due date is
automatically extended if the sponsor’s tax return is extended.
Of course, recreational preparation of unnecessary 5500s is still
permitted, but don’t show them to anyone.
DID YOU KNOW?
All prior issues of the Tax Update are available at our website, www.rothcpa.com.Go
there and click on “Tax Updates.”
The IRS has just blessed a new type of employer heath plan that
permits employees to carry over unused reimbursement dollars from one year to the next,
and even into retirement.
There is one catch: the employer must fund the reimbursement account.Employee dollars cannot be used.
The plan approved by the IRS in Rev. Rul. 2002-41 features
high-deductible health insurance, accompanied by individual employer-funded reimbursement
accounts (“health reimbursement arrangements,” or HRAs) that employees can tap
to cover deductibles and other out-of-pocket medical expenses.If an individual does not use his entire employer
HRA contribution in a given year, it carries over to subsequent years.The HRA may also allow unused amounts to be tapped
for documented medical expenses after retirement.Cash
withdrawals, however, are not available.
The HRA plan in Rev. Rul. 2002-41 resembles a Medical Savings Account
(MSA) in some respects.It is designed to
reduce total health costs by giving the participants responsibility for more expenses,
accompanied by an opportunity to build up an account for retirement health costs.In a companion announcement (Notice 2002-45), the
IRS makes clear that the employer-funded accounts may be used with a more conventional
health plan.
This plan is likely to be carefully evaluated by employers if the
reduced premium costs available using high deductible plans offset the need to make
employer contributions to the HRA.As these
plans lack the bureaucratic red tape found in MSAs, they might become more popular.
A Medical Savings Account is an individual IRA-like account that can
be opened in conjunction with a qualifying employer-sponsored or self-employed health
insurance plan.For family coverage, the plan
deductible needs to be between $3,300 and $4,950, with an out-of-pocket maximum of no more
than $6,050.These amounts are lower for
single-person coverage.
Individuals can make tax deductible contributions to their MSA; the
maximum 2002 contribution is $3,712.50 (75% of the maximum allowed deductible).They can withdraw amounts tax free up to the
amount of out-of-pocket expenses.Amounts
not withdrawn accumulate on a tax-deferred basis and can be withdrawn at retirement much
like IRAs.
The concept is a small-scale version of a typical self-insured
corporate health plan, where the company pays health-claims out of its own funds but
maintains a stop-loss for major claims.The
MSA is conceptually a personal self-insurance reserve.As a practical matter, MSA participants often allow their MSA contributions
to accumulate and pay their medical expenses using other funds; this allows MSA funds to
accumulate tax-free.
The IRS has a surprise in store for many partners and S corporation
shareholders.Perhaps sensing that not all
income reported to partners and shareholders on their K-1 forms is being properly
reported, the IRS recently announced that it will start automatically matching partners
and their K-1s.According to an IRS
spokesman, the IRS will match data from up to 16.8 million K-1 forms filed for 2001.
Anecdotal evidence suggests that not all K-1 income is punctiliously
reported.Experience suggests automated
matching can improve compliance a lot.For
example, when dependent social security numbers were first matched on Form 1040, millions
of dependents mysteriously vanished from tax returns filed the following year.
Absent a mass alien abduction, we can assume that the matching program for the dependent
social security numbers was responsible.
The Seventh Circuit Court of Appeals recently upheld a Tax Court
decision denying “Married Filing Jointly” status to a male couple (Robert D.
Mueller v. Commissioner)The court held
that as the couple was not married pursuant to governing state law (Illinois), the
partnership was ineligible to file a joint return.The
court declined to allow joint filing status for the partners under a constitutional
“equal protection” argument.
DID YOU KNOW?
You can now find the new Required Minimum Distribution tables
for IRAs and Qualified plans on our “Links” page? Go to www.rothcpa.com and click on the “Links.”
The Senate has failed to repeal the repeal of the repeal of the
estate tax.This means that the estate tax is
still scheduled to go away in 2010, only to return in 2011.
While aggressive tax planning would indicate the need for mass
suicide in December 2010, we strongly believe that non-tax considerations should be given
precedence here.What estate planning moves
are appropriate for someone who wants to stick around awhile after 2010?
RECONSIDER AUTOMATIC PROVISIONS IN YOUR WILL.Many wills provide that the children receive the
maximum amount they can receive without incurring estate tax – generally the lifetime
exemption (unified credit amount) -- with anything left going to the surviving spouse.These provisions were written when the lifetime
exemption was $600,000.It is now $1,000,000,
and it will reach $3,500,000 in 2009.Many
folks may not wish to be so generous to their children, at least at the expense of their
surviving spouse.At the very least, these
amounts should be funneled to a “credit shelter trust” that permits
distributions in support of a surviving spouse.
AVOID TAXABLE GIFTS.Paying
gift taxes used to be a good estate planning strategy, as the effective tax rate on gifts
is lower than the effective rate on amounts passing at death.If there will be no estate tax, however, gift
taxes lose what little allure they have.As
long as estate tax repeal is still scheduled to be in place at some point, there is a
strong likelihood that changes in the makeup of Congress will make the estate tax go away.It may take just a one-seat gain by the
Republicans in the Senate elections this fall to make the estate tax go away permanently.Given this possibility, paying gift tax seems like
a poor idea, unless you are pretty sure to leave this world between 2005 and 2010.
DON’T COUNT ON THE DEMISE OF ESTATE TAX.Permanent repeal of the estate tax is nowhere near
as sure as death or taxes.The
President’s party usually loses congressional seats in mid-term elections; if that
happens this fall, permanent repeal is probably off the table until at least 2005.Taxpayers with enough net worth to worry about the
estate tax should continue to make annual gifts up to the $11,000 annual exclusion.They should strongly consider gifts of minority
interests in businesses, and allocation of assets to their spouse; such tactics can reduce
the taxable value of such assets by 30% or more.
Perhaps Congress is playing a deeper game than anyone realizes.Is the one-year repeal of the estate tax a
diabolical scheme to cause enough tax-motivated deaths in 2010 to ensure the long term
solvency of Social Security?Could they be
so smart, so clever, evil and audacious, to come up with such a wickedly brilliant plan?
The IRS yesterday ruled that the effective date for closing a short
sale of stock depends on whether the position is closed out at a gain or a loss.In Rev. Rul. 2002-44, the service ruled that
positions closed out at a gain (the stock price has declined) are recognized on the trade
date.If a short sale is closed out at a
loss, however, the loss is recognized only when the stock to close out the sale is
delivered – typically several days after the trade date.Taxpayers wishing to recognize short sale losses
at year-end will need to make sure the trade is made in time for delivery to occur before
year-end.
The Iowa Research Credit is “refundable?”This means if your Iowa Research Credit exceeds
your taxes for the year, you still receive the full credit.For example, a taxpayer with $0 taxable income and a $1,000 Iowa Research
Credit would receive a $1,000 check from the state – even if no withholding or
estimated taxes were paid to Iowa during the year.
ISU GRADUATE JOINS ROTH AND COMPANY
Heather Griffieon (pronounced “Griff-fune”) has joined Roth & Company.An Iowa State graduate, she will work primarily in
the tax area.
When the death tax was “repealed” last year, it turned out
there was a catch: the repeal only applied to deaths in 2010.In 2011, the pre-2001 rules will return, including
the estate tax, absent further legislation.
Hoping to fend off an avalanche of tax-motivated deaths in December
2010, including perhaps their own, the House of Representatives voted to make the repeal
permanent after 2010.
Will the Senate, with a much higher percentage of members likely to
face hefty estate tax liability, go along?A
close vote is expected on this issue before July 4.The
pro-repeal forces, which include almost all Republican senators and several Democrats,
need 60 votes under Senate rules to make the repeal permanent.Democratic leaders are expected to approve an
increase in the lifetime exemption to $3,000,000 (compared to the current $1,000,000) to
keep waverers from supporting permanent repeal.Suspense
abounds, so stay tuned.
The only certain thing about state corporate income taxes is that
they are a rich source of fees for practitioners.This
great news (ok, we’re tax practitioners and we like rich fee sources) was relayed by
David Brunori, an editor of the publication State Tax Notes, in a recent speech to
the Federation of Tax Administrators.Brunori
says that some states with corporate income taxes make more money from their lotteries.He adds that when compliance and enforcement costs
are considered, state corporate taxes are very inefficient.
According to Brunori, “The truth is that a small segment of the
private bar and accounting profession are making a lot of money figuring out how to plan
around the tax. The only other folks with whom I have spoken who really love the tax are
state economic development officers.The
system allows them to give tax breaks to companies promising to locate to or remain in
their state. I had a very wise man tell me that the corporate tax is like the cookie jar
for those in the economic development business."
Gee, does this mean that lower tax rates and tax simplification could
provide economic development for everyone, rather than just those with good lobbyists?What a concept.
The Iowa Legislature meets for its second special session of the year
today.Rumor has it that this time they will
actually legislate something.Let us take a
moment to look at the tax accomplishments of their last regular legislative session.
VENTURE CAPITAL CREDITS were the major bipartisan tax policy goal of
the recent session.The governor has signed
four new sets of venture capital incentives.
THE “FUND OF
FUNDS” CREDIT (HF
2078) is part of a program to set up a state-sponsored pool to invest in other venture
capital pools.The credit is designed to
guarantee a minimum return to investors in the Fund of Funds; to the extent returns of the
fund fall short of a benchmark rate – approximately 1 ½ % over the 10-year treasury
rate – taxpayers will get an offsetting credit against their Iowa taxes.
THE
“COMMUNITY-BASED SEED CAPITAL FUNDS” CREDIT (HF
2271) allows a 20% credit for investors in locally-run investment pools investing in
Iowa businesses.
THE CREDIT FOR
DIRECT INVESTMENTS IN “QUALIFYING BUSINESS” (HF2271)
provides a credit of up to 20% of direct investment by individuals.A“qualifying business” is one with a net
worth of up to $3,000,000 with principal operations located in Iowa, and with owners who
meet certain training or experience requirements.The
business cannot be “primarily engaged in retail sales, real estate, or the provision
of professional services.”
THE VENTURE
CAPITAL FUND INVESTMENT CREDIT (HF
2586) provides a 6% credit to taxpayers investing in venture capital funds with a
physical presence in Iowa and a commitment to consideration of Iowa enterprises in
allocating its investments.
CREDIT NOW, CASH LATER.All
of these credits can be generated by investments made now, but the credits will only
offset taxes in future years.The
legislation limits the total amount of credits available under these provisions.A state board will dole out the available credits.
WHAT ABOUT THE
BUSINESSES? The legislature also provides a direct benefit for recipients of venture
capital funds by allowing some businesses to defer its state taxes for the first three
years of operation; these taxes would be paid interest-free over the five years subsequent
to the three-year initial holiday (HF
2592).
What if the funding of your small business is from your own savings,
or from your family, or your friendly banker?Tough
luck, pal.Only businesses funded at least
25% from venture capital funds qualify for this holiday; if they are your competitors,
them’s the breaks, per the legislature.
S CORPORATIONS with sales outside of Iowa caught a break this year.Iowa law provides a tax credit for such
corporations based on the portion of sales to non-Iowa destinations.The credit had been reduced when S corporations
made distributions to cover their federal taxes.This
will no longer be the case, effective in 2002.Distributions
in excess of federal tax needs will still reduce the credit.
ILLIOWANS also got a break when the legislature voted to maintain the
“reciprocity” agreement with Illinois.This
agreement allows residents of Iowa who work in Illinois (and vice-versa) to only file tax
returns in their home state.Governor Vilsack
had intended to terminate the agreement to help close the state’s budget gap.
DEPRECIATION got more complicated for Iowans.The federal government’s “stimulus”
bill provided a 30% up-front depreciation allowance for assets placed in service after
September 10, 2001 and before September 11, 2004.Iowa
declined to go along with this provision, forcing Iowa businesses to maintain separate
state-only depreciation schedules.
SOME OTHER STATES have also chosen to complicate the tax lives of
their taxpayers by opting out of the new federal rules.Minnesota just decided to not adopt the 30% stimulus depreciation.Nebraska allows it only in part.Wisconsin has rejected the new federal
depreciation system, and Illinois is likely to as well.
New tax year, that is.The
IRS last week changed the rules for allowable taxable years for “pass-through
entities” -- partnerships and S corporations.Most
pass-throughs will be able to keep their current taxable year.Some, however, will have to make a change.
Since 1986, the calendar year has been the default tax year for
pass-throughs.Some have taken advantage of
the “Section 444 election” to have a September, October or November year-end.
Others have been able to have other year-ends because their majority owners have been on
non-calendar fiscal years, or because of “grandfather clauses” in the 1986 tax
law.
Taxpayers with interests in pass-throughs are taxed on income for the
pass-through entity years ending with or during their own tax year.Almost all individuals are calendar year
taxpayers.If an individual owned an S
corporation with, say, a January 2002 year end, she would pay the taxes on the income with
the 2002 tax return due on April 15, 2003 -- even though 11/12 of the income would have
been earned in 2001. This would give taxpayers an 11-month deferral of taxes on the
pass-through income.Needless to say, this
deferral is not popular with IRS, and the ability to have taxable years offering deferral
has been greatly reduced over the years.
Of course, tax practitioners love non-calendar fiscal years because
they help them to spread out their workload.
The taxpayers are most likely to be affected by the new rules are S
corporations with an Employee Stock Ownership Plan (ESOP) as majority (but not 100%)
owner.
ESOPs have only been allowed to own S corporation stock since 1997.ESOPs have great flexibility on fiscal years.Many ESOP-controlled corporations have made S
elections over the last few years because ESOPs pay no tax on their S corporation income.Under prior rules, S corporations with majority
ownership in an ESOP had to go to the ESOP year end – even if it was January –
providing considerable tax deferral to the individuals with minority stakes.Under the new rules, the ESOP will be ignored in
determining the majority ownership of an S corporation (except when the S corporation is
100% owned by the ESOP), generally forcing the corporations onto a calendar year.
The IRA contribution limits have increased to $3,000 this year.The limit had been $2,000 for many years.If you are over 50, you can throw in an additional
$500 “catch-up” contribution.This
limit applies both to traditional IRAs (whether or not deductible) or Roth IRAs. You can
make a contribution for 2002 as late as April 15, 2003, but the sooner you make your
contribution, the sooner you start to benefit from the tax-free buildup of IRA earnings.
The deductibility of contributions to traditional IRAs is phased out
for taxpayers who participate in employer pension, profit-sharing or 401(k) plans as their
income exceeds certain thresholds.The
phase-out starts at $54,000 adjusted gross income (AGI) for married taxpayers and $34,000
for single taxpayers.There is no income
ceiling for non-deductible contributions to traditional IRAs.
The ability to make Roth IRA contributions begins to phase out for
married taxpayers with AGI over $150,000 and for single taxpayers with AGI over $95,000.
Sentimentalists say that home is where the heart is.The less sentimental folks at IRS insist that your
tax home is your principal place of business.When
the question gets to the courtroom, the sentimentalists haven’t a chance.
Barry Knelman started a business in the 1980s maintaining indoor
plants for businesses in Southern California.For
reasons of the heart – to be closer to their family – Mr. Knelman and his wife
moved to Ohio in 1991.He regularly returned
to California to manage the business.Naturally,
he sought to deduct his travel costs. The judge looked at the problem in a distinctly unsentimental light:
“In the instant case, we find that Mr.
Knelman's primary motivation in traveling between Ohio and California was to commute
between the locations of his chosen residence and business. Had petitioners remained in
southern California, their traveling expenses between work and home would also have been
nondeductible commuting expenses. The distance traveled, no matter how far, does not
change the character of the commuting expense.”
Taxpayers with more than one place of business often can get a better
deal.Taxpayers who live near their principal
place of business can usually deduct their travel to a minor place of business.But don’t be TOO successful at the remote
location – if it grows to become your “primary” business, you won’t be
able to deduct the costs of traveling there.
You may exclude from income gain up to $500,000 ($250,000 for single
taxpayers) on the sale of a principal residence as long as it has been your principal
residence for at least two years out of the previous five years, and you have not excluded
a gain from the sale of another residence within 2 years of the sale.If you have depreciated the house because you have
used it in your business or for rental, you cannot exclude gain up to the amount of
depreciation that has been taken.
Of course, the exclusion is the easy part.The hard part is turning that $500,000 profit on
the house.
Taxpayers may deduct moving expenses related to a new principal place
of work. The tax law limits the deductible costs of the move to the costs of moving your
bodies and your belongings to the new spot.House-hunting
costs and temporary living expenses are no longer deductible.If you drive, you may deduct either actual
out-of-pocket expenses or a straight 12 cents per mile.
Whenever a legislature comes into session, there is always a real
risk of legislation occurring.We dodged that
bullet last week when the legislature assembled at the call of the Governor.After a few speeches, and before a single $3
lobbyist-financed lunch, they ended the special session and went home.
No complicated new tax credits.No new tax exclusions for emu ranchers with century farms.Other than the $38,000 cost of the session, there
was no damage done at all -- surely a historic achievement from a state tax policy
perspective.
But we are not yet out of the woods.The Governor remains unhappy with the budget enacted in the regular session
that ended earlier this month.Another
special session remains a distinct, sobering possibility.
There seems to be a dawning sense that Iowa’s state income tax
system is not a help in growing the state’s economy.Senator Larry McKibben, Chairman of the Senate Ways and Means Committee, has
announced that he will introduce a “flat tax” plan in the next regular session,
based on the Illinois income tax system.Perhaps
someday Iowa will not have higher tax rates than all of its neighbors.
Congress remains in business, but the prospects for any additional
tax legislation this year are uncertain.Pension
and ESOP legislation may be passed in reaction to the Enron scandal.Limited energy tax incentives may be enacted, as
may some bankruptcy provisions.With the
current partisan divide in Congress, expect little.
The administration issued the first of a planned series of reports on
suggestions for tax simplification.The
report includes a proposal for a uniform definition of “child” for five
different tax law provisions.
The need to reconcile five different definitions of child shows how
far gone the tax law is.
Earl and Mildred Koester tried to do the right thing.Even though Earl’s schooling ended after
eighth grade, the couple was savvy enough to hire an attorney help draft their wills.They went on to the next world secure that the tax
rules of this one had been properly dealt with.
They were wrong.The
will failed to properly use the taxpayer’s unified estate tax credits, and the estate
of Earl, who died after Mildred, ended up owing $109,000 in estate tax.
Earl’s estate argued in Tax Court that the estate tax laws are
so complex that they deprive the “less well-educated” of their constitutional
right to equal protection under the laws.The
judge wasn’t convinced (Estate of Earl C.
Koester, TCM 2002-82).
“We find the estate's argument is misguided. The
Koesters were free to will their property in accord with their wishes. They hired an
attorney to provide legal assistance in their choices of disposing of their estate. On the
record before us, we cannot determine whether the Koesters were aware of the provisions
that the estate contends would have obviated the incidence of estate tax. We are limited
to considering the tax ramifications based on the facts at hand, not what may have
otherwise occurred.”
The Koester’s will failed to
make full use of their “unified credit.”Under
current law, each taxpayer gets to exclude their “unified credit amount,” the
so-called “lifetime exclusion,” from lifetime gift tax and, to the extent not
used for gifts, from estate tax.In 2002,
each taxpayer can exclude from estate and gift taxes a combined $1,000,000 in lifetime
gifts or taxable estate.When the Koesters
died, the unified credit amount was $600,000 per taxpayer.
The Koester’s wills gave all of
the assets of the first spouse to die outright to the surviving spouse; they passed tax
free because all marital gifts and bequests are free from estate and gift tax.Their problem was that their combined estates,
while less than the $1,200,000 amount that two taxpayers could pass tax-free, exceeded the
$600,000 limit for one taxpayer.When all of
Mildred’s assets passed to Earl, her $600,000 lifetime exclusion went unused, and
Earl’s net worth crept over $600,000.When
he died, estate tax resulted.Had
Mildred’s estate passed to their children, rather than Earl, his estate tax would
have been $0, instead of$109,000.
The standard way to avoid the
Koester’s problem is a “credit-shelter trust” will.At the death of the first spouse to die, an amount
– typically up to the amount of the lifetime exclusion – is put into a
“credit-shelter trust.”This trust
distributes its income to the surviving spouse; it may also distribute additional amounts
as needed for the support of the surviving spouse. The credit-shelter trust is not
considered part of the estate of the surviving spouse.Its assets generally pass tax free under the lifetime exclusion to the children at
the death of the surviving spouse.This use
of the exclusion amount in the estate of the first spouse to die often reduces the estate
of the surviving spouse enough to eliminate estate tax for both spouses (it would have for
the Koesters).
All remaining assets of the first
spouse to die go to the spouse outright or into a “marital trust,” which is at
the complete disposal of the surviving spouse.
If you aren’t sure your will has
a credit-shelter trust provision, you should consult your tax advisor.
