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Tax Update Blog: August 2002 Archives

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August 28, 2002

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.

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August 28, 2002

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.

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August 28, 2002

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.


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.

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August 21, 2002

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.

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August 21, 2002

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:

  1. 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.
  2. 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.

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August 21, 2002

The IRS has issued the minimum rates to be charged for loans made in September 2002:

  • Short-Term (demand loans and loans with terms of 1-3 years): 2.13%
  • Mid-Term (loans from 3-9 years): 3.75%
  • Long-Term (over 9 years): 4.63%

For complete historical AFRs, click on the Links page.

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August 14, 2002

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.

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August 14, 2002

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.

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August 14, 2002

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.

Of course, you have to drive this to use it.

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