Tax Update Blog: June 2003 Archives

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PAYBACKS ARE HECK...

June 30, 2003

...especially when it is your paycheck.

John Merritt, a personal injury attorney in Oklahoma, decided in December to return $128,000 of his salary for the year to his professional corporation. The Tax Court today said that trick doesn't work.

We can only guess why Mr. Merritt decided to return his paycheck. He may have determined that the corporation would have a loss for the year (a forlorn hope, based on the case); in that event, he didn't want to pick up the income on his 1040 when there was no currently useful deduction on the corporate return. Or, perhaps, he just decided he really hadn't rightly earned the money (um, right).

NO DEDUCTION UNTIL THE CASE IS DONE

Mr. Merritt may have felt he had a loss in his corporation because the corporation deducted the costs he incurred in contingent fee cases before the case was decided. The Tax Court said that such costs are treated as loans to clients, not as expenses. Mr. Merritt said that he should be treated differently because he didn't investigate the creditworthiness of his clients. The Tax Court disagreed.

WHEN ALL ELSE FAILS, BLAME THE ACCOUNTANT!

Mr. Merritt used the "it's the accountant's fault!" gambit to avoid penalties for late filing and for substantially understating his income. It worked for substantial understatement penalty, but not for the late-filing penalty.

THE MORAL:

Attorneys might be able to blame bad deductions on the accountant, but if the return is late, the Tax Court judges may not extend further professional courtesy.

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IOWA TO ACCEPT INCREASED SEC. 179 DEDUCTION

June 30, 2003

The Iowa Department of Revenue and Finance (Department of Revenue starting tomorrow) last week said that Iowa will go along with the increase in the Sec. 179 deduction enacted in the recently signed Jobs and Growth Tax Relief Reconciliation Act.

Sec. 179 allows taxpayers to expense property that would otherwise be depreciated. The new law increased the annual limit on the Sec. 179 deduction to $100,000 (it had been $25,000). The new law also extends the deduction to software. Most real estate does not qualify for the Sec. 179 deduction.

BUT NO BONUS

Iowa does not accept either the 30% "bonus" depreciation enacted by Congress in 2002 or the 50% bonus depreciation in the 2003 act. Taxpayers compute their Iowa depreciation under the pre-2001 laws for bonus depreciation property.

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A ROSE BY ANY OTHER NAME...

June 26, 2003

The Iowa Department of Revenue and Finance, after a run of several years, has decided that there is no "Finance" in the department. The department becomes the "Department of Revenue" on July 1. They say they are making the change because of the move of the State Accounting Bureau to another department, but we think they just disliked the "DORF" acronym. It's no accident that they didn't become the "Department of Revenue Collection."

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IOWA SUPREMES: NONRESIDENT S CORPORATION SHAREHOLDERS NOT TAXED IN IOWA ON "NONBUSINESS" INCOME

June 26, 2003

Taxpayer Wayne lives in Idaho. He has an old savings account account in an Iowa bank. As an Iowa non-resident, he reports the interest income on his home state return, and not in Iowa.

Wayne puts the savings account in his wholly-owned Iowa S corporation, Thor, Inc. Thor's only other asset is an Iowa farm. Because Thor is an S corporation, Wayne pays tax on all of Thor's income on his 1040. Should Wayne start paying tax on the savings account income just because it is now in an S corporation?

We would have always said "no," but the Iowa Department of Revenue and Finance urged the Iowa Supreme Court to just say "yes." Fortunately, the Supreme Court earlier this month agreed with us.

COMACHO AND STANKEE.: LOSS FOR THE TAXPAYERS, BUT VICTORY FOR TAX POLICY

Jill Camacho lived in Wisconsin; her brother, Glen Stankee, lived in Florida. Both Jill and Glen owned small interests in an Clark Farms, Inc., an S corporation that owned farmland in Clinton County, Iowa. The S corporation earned some interest income in addition to the farm business income. Jill and Glen did not pay Iowa tax on the interest income shown on their Clark Farms K-1. The DORF said they should, and the case went to court.

The DORF argued that nonresidents should pay tax on all interest income of an Iowa-domiciled S corporation, whether or not the income is "business income." The taxpayers argued that they should not have to Iowa pay tax on the interest income because it was "non-business" income (among other arguments).

The Court ruled against the DORF on the law, holding that non-residents are not taxable in Iowa on their share of S corporation non-business income. The Court then ruled against the taxpayers on the facts, saying that they failed show that the interest was non-business income; as "business" income, it was taxable to Iowa along with the farm business income.

BUSINESS V. NON-BUSINESS INCOME

Iowa S corporations with non-resident shareholders should distinguish between "business" and "non-business" income in their investment portfolio. The distinction is fuzzy; the Court turned to Iowa's tax regulations, citing two examples as "particularly relevant":

EXAMPLE D – An Illinois resident has Iowa farms. The Illinois resident invests the profits from the farms in a savings account in an Iowa bank. Several times a year, the taxpayer transfers part of the funds from the savings account to the taxpayer’s checking account to purchase machinery to be used in the farming operations. The interest income would not be included in income allocated to Iowa since the interest income is not derived from the taxpayer’s trade or business nor is the savings account utilized as a business account.

. . . .

EXAMPLE F – A nonresident has a farm in Iowa which is the nonresident’s principal business, although this person is an Illinois resident. The nonresident has an interest-bearing checking account in an Iowa bank. This checking account is used to pay personal expenditures as well as to pay expenses incurred in operation of the farm. In 1982, the taxpayer will earn $550 in interest from the checking account. The interest would be included in net income allocated to Iowa since the interest is derived from the business, generated from a business account, and utilized in the business.

The regulations tell us that extra funds should be moved to accounts not used in day-to-day business activity if the taxpayer wants the earnings on the funds to be treated as "non-business" income.

THEY MEANT WHAT THOSE FORMS SAID!

Iowa's K-1 for non-resident S corporation shareholders has always had an annoying feature: it allocates interest and dividend income to non-residents in the same way it allocates business income. We always assumed that was a result of lazy draftsmanship; after all, everybody knows that non-business income is taxable only in the resident state, right? But Camacho and Stankee shows that they actually meant what the forms said. Fortunately, the case also shows we properly ignored the form instructions! (whew.)

A REFUND OPPORTUNITY?

Iowa non-residents who have paid Iowa tax on their S corporation non-business income now should file refund claims on form IA-1040X. The statute of limitations for the refund claims is normally three years.

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IRS NOW OFFERS TAX IDENTIFICATION NUMBERS ONLINE

June 25, 2003

The IRS now allows taxpayers to apply online for new tax identification numbers. These are needed whenever taxpayers set up a new corporation, partnership, trust or proprietership with employees.

The online application has been added to the "links" page at www.rothcpa.com.

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NOTICE TO IRS EMPLOYEES: THIS SITE IS WORK RELATED!

June 23, 2003

The Treasury Inspector General for Tax Administration (TIGTA) last week reported shocking news: many IRS employees spend work time in internet chat rooms and naughty sites.

Tax Analysts reports:

"Monitoring Internet usage during the week of October 20, 2002, investigators discovered that more than 1 million forbidden Web page elements were accessed from about 19,000 IRS computer network addresses. And though they described inappropriate use of the Internet at the Service as 'widespread,' investigators found that 28 percent of the salacious elements were accessed from only 122 computers, suggesting a smaller group of chronic abusers, the report found. "

This is an interesting dilemma. Are taxpayers better off if IRS employees spend their time transfixed by inappropriate web sites, instead of inappropriate deductions? Senate Finance Committee Chairman Charles Grassley, for one, doesn't think so: "Nobody should collect a government salary to sit on their behinds and play around in chat rooms, or worse, all day."

Of course not. Wasting time on the web is a privilege reserved for private sector employees.

Unfortunately, the report is not yet posted on the TIGTA web site.

UPDATE: It is now.

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NEW TAX LAW COMPLICATES MARGIN INTEREST

June 20, 2003

Great tax minds were dreaming up wonderful new ways to play with the 15% top rate on dividends before the ink dried on the new tax law. One great, if flawed, idea goes like this:

Richie Rich has $100 ordinary income, $50 from his CEO job, and $50 from rental properties, bonds, and other investments. He normally takes home $62 ($100 less $38 tax).

Richie Rich borrows $1000 from the bank at 10% interest. He invests the $1000 in the preferred stock of GE, which pays a 8% coupon. Each year, Richie gets $80 income from the preferred stock, taxed at a 15% rate, for a net of $68 ($80 income less $12 tax). Richie pays $100 in interest, and gets a $100 deduction. Richie's interest deduction offsets the ordinary income from his CEO job and rental properties. Richie thus pays zero tax on his ordinary wages and other investments, and nets the $68 from the preferred stock.

Richie Rich has thus increased his take home from $62 to $68. The results are even better if the spread between the interest rate and the preferred stock rate is narrower. (Example from A Taxing Blog.)

SO WHAT'S THE PROBLEM?

Anytime you give preferential rates for one type of income, doors can open for this sort of rate "arbitrage." Congress, sensitive to the issue, used the investment interest deduction limitations to address this transaction. These rules limit the deduction for interest expense used to purchase or carry investment assets to the amount of the taxpayer's "investment income"; any excess investment interest expense is non-deductible and carries to future years.

The new law allows taxpayers to treat dividends as "investment income" only if they forego the 15% rate. In the example above, Richie Rich would either have to pay tax at 35% on the preferred stock dividend or forego the investment interest expense deduction.

WHEN ONE LOOPHOLE CLOSES, ANOTHER ONE OPENS

Richie's plan still can work if Richie has some other source of investment income. If, for example, Richie was the beneficiary of a trust that paid him $80 of taxable interest income, the plan would work just fine; he would be able to offset the $80 of interest expense against his trust earnings and still pay tax of only 15% on the $80 of dividends. And calm is restored.

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JULY 2003 AFRS ISSUED

June 20, 2003

The IRS has issued (Rev. Rul. 2003-71) the minimum rates to be charged for loans made in July 2003:

Short Term (demand loans and loans with terms of 1-3 years): 1.23%
Mid-Term (loans from 3-9 years): 2.55%
Long-Term (over 9 years): 4.17%

Historical AFRs are available on the “Links” page at www.rothcpa.com.

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GOT MOLDS? IOWA ENACTS TAX BREAK FOR FOUNDRIES.

June 20, 2003

While Iowa cranks up it's "Values Fund" to attract high-tech businesses, the old economy hasn't been forsaken by the legislature. The Governor recently signed HF 654, exempting sales and rentals of mold-making machinery from Iowa sales and use taxes. Refunds on such sales may be available as far back as as July 1, 1997. . But act now! Total refunds are limited to $600,000, and claims must be filed by October 1, 2003.

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GOVERNOR USES THE ITEM VETO. WILL IT STICK?

June 19, 2003

The Iowa Legislature passed a complex package of economic development subsidies and tax cuts and passed it to the Governor with the choice: take it or leave it.

The Governor today made his choice: "yes."

Governor Vilsack today unleashed his "item veto" on the economic development package today, taking his "Iowa Values Fund" to enactment while leaving the tax cuts in the leglislative dumpster.

The item veto is likely to trigger a lawsuit by the Republican leadership. If the lawsuit succeeds, the tax cuts will become law, according to The Des Moines Register; if it fails, the Republican leadership may feel a bit silly for passing a compromise package without, well, an actual compromise.

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FLAT TAX, ONE SLICE AT A TIME

June 17, 2003

The Washington Post has noticed how far down the road the Administration has moved the tax system towards a "flat tax" or "consumption tax - a trend we discussed back in February. The tax changes passed since January 2001 have reduced the rate of taxation of investments; classic "flat" taxes eliminate such taxes entirely.

This tax reform in small pieces enables the passage of popular tax breaks without a discussion of the "fairness" of a flat tax, a trend that strikes some as unhealthy. (Via A Taxing Blog)

The article discusses an apparent debate within the Administration over the direction of tax policy in the next year. One group wants to continue this trend, perhaps by pushing the simplification and expansion of retirement savings incentives proposed earlier this year. Others are reluctant to revisit the tax law, fearing a backlash if the changes go too far.

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CAN GOVERNOR USE LINE-ITEM VETO FOR TAX CUTS?

June 13, 2003

The Iowa legislature last week sent a package of tax cuts to the Governor as part of an "economic development" package. According to The Des Moines Register, Governor Vilsack is pondering the use of his line-item veto to snip the tax cuts from the package.

It is unclear whether this is an option for the Governor. The line-item veto is available only for "spending" bills. The legislature attempted to make sure the tax cuts weren't part of an "appropriations" bill to preclude a line-item veto. It depends, apparently, on what the meaning of "spend" is.

The legislative leadership threatens a court fight if the line-item veto is used. It might also mark the end of any cooperation between the legislature and the Governor. This could get interesting.

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HOLD THAT STOCK! (AT LEAST LONG ENOUGH TO GET THE 15% RATE)

June 11, 2003

Today's lesson: a great tax scheme that doesn't work - and a moral for careful taxpayers.

THE SCHEME: Taxpayer Tim has a clever plan to game the new 15% top rate on dividends. He buys a stock that reliably pays a $1 dividend the day before it goes ex dividend, paying $20 for the share. The day it goes ex-dividend the price goes down by $1 because the dividend stays with the seller. Tim sells the share for $19. Tim chuckles to himself: "I get a $1 dividend, which will cost me 15 cents in federal taxes. I get a $1 short-term capital loss, deductible in full (up to $3,000), giving me a deduction worth 35 cents at my 35% tax rate. I get 20 cents net tax savings for almost no risk! Heh!"

THE SNAG: The 15% rate only applies when a stock is held for at least 60 days during the 120-day period starting 60 days before the ex-dividend date and ending 60 days after the stock goes ex-dividend. If the holding period requirement is not met, the dividend is taxed at regular rates. Preferred stock must be held for 90 days out of a 180-day period.

THE MORAL: Taxwriters think a step or two ahead. Sometimes. If it seems too easy, maybe it doesn't work. Watch your sale dates; if you flip a stock too quickly, you won't get the 15% rate.

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IOWA DEPARTMENT OF REVENUE 9, PRAIRIE MEADOWS 0

June 10, 2003

The U.S. Supreme Court yesterday unanimously reversed the Iowa Supreme Court in upholding Iowa's two-tier gambling tax. In short, the Supremes said the courts should avoid deciding whether legislation has a "rational basis."

The Des Moines Register's coverage says the case is "far from over" because the case is now back in the hands of the Iowa Supreme Court. The track's attorney gamely holds out hope for a victory there:

"We remain optimistic that the Iowa Supreme Court, which has the opportunity to interpret this law once more solely upon the Iowa Constitution, will again conclude there was and is no rational basis to tax racetracks at 36 percent and riverboats at 20 percent."

This may be unduly optimistic. It appears that the Iowa court would have to change its long-held position that the U.S. and Iowa constitutions use the same "equal protection" standards - the position that got this case to the U.S. Supreme Court in the first place. After a nine-judge slap by the Supremes, it seems unlikely that the Iowa court would stick its neck out to give victory to the track.

A Taxing Blog provides a smart and concise discussion of yesterday's decision. The article uses the term "Lochneresque"; I think this explains what that word means. If it means something else, we hope it's clean.

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GOVERNER VILSACK AND TAX CUTS: WILL HE OR WON'T HE?

June 09, 2003

Governor Vilsack has not yet announced whether he will sign the tax cut passed by the Iowa legislature last week. Tax Analysts cites "sources in the Governor's Office" as saying the tax cuts face an "almost certain" veto.

The bill would trim individual tax rates over the next four years. It would also provide for deeper cuts in 2007, combined with the elimination of the deduction for federal taxes, if a constitutional amendment requiring a 60% majority for tax increases is enacted.

Constitutional amendments have to be passed twice by the legislature and then approved in a referendum to take effect. Even if the Governor signs the tax bill, passage of the constitutional amendment is not a foregone conclusion.

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PLUMBERS: WE WILL EMPHASIZE PIPES

June 09, 2003

Tax Analysts reports that "The Internal Revenue Service plans to put more emphasis on enforcement," disappointing the many taxpayers who would prefer the IRS emphasize coffee and doughnuts.

The Tax Analysts story covered a speech by Kevin Brown, Chief of Staff to the IRS Commissioner. Mr. Brown pointed to the IRS offshore compliance efforts, which included the now-expired "Offshore Voluntary Compliance Initiative." Mr. Brown says the IRS will "inflict some pain" on thise with money stashed offshore who passed up the opportunity to come clean. Hinting that the IRS will go after some celebrities of some sort, Mr. Brown teased "you'll see names you recognize."

The IRS apparently has a lot of work to do; Mr. Brown says that its "database" of abuse tax scheme promoters has increased to 888, from a mere 25 in 2001.

The speech also provided tantalizing clues about how tax policy makers spend their free time. Mr. Brown illustrated the importance of credit cards to offshore tax schemes with a "Star Trek" parable:

"In the classic TV drama, the Romulan enemies used a cloaking device to hide from Federation warships. But when firing weapons, Romulans were forced to drop their cloaking device, if only for a moment. Credit cards, Brown suggested, have a similar effect on offshore funds; normally hidden from U.S. tax authorities, funds become visible whenever a credit card is used to access them."

Mr. Brown didn't explain how he manages to watch Star Trek and deal with tax policy while having a successful season with the L.A. Dodgers.

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IOWA SENATE SENDS TAX CHANGES, VALUES FUND TO GOVERNOR

June 04, 2003

The score: Tax Bill 27-20; Values Fund 28-19.

An updated bill text of HF 692 is available.

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IOWA HOUSE STAYS UP LATE, PASSES TAX CHANGES

June 04, 2003

Around 1:00 this morning the Iowa House of Representatives approved a reduction in state income tax rates over the next four years. The plan also includes a dramatic reduction in rates in 2007, coupled with the elimination of the deduction for federal income taxes - but only if an amendment to the state constitution requiring 60% approval of tax increases is approved.

The bill trims individual income tax rates across the board. The top current rate of 8.98% would fall to 8.82% in 2004, 8.48% in 2005, 8.15% in 2006, and 7.61% in 2007.

If the constitutional amendment is passed, the 2007 rate will instead 4.9%, and the current 9 brackets would be compressed to 3. Federal deductibility would be eliminated, but all other itemized deductions would remain in place.

GOOD NEWS FOR TAX PREPARERS. The bill appears to make no changes in Iowa's highest in the nation 12% corporate income tax rate, and it makes no other simplifying changes in our tax rules. It's nice that the Legislature looks after the interests of those of us who charge for tax advice by the hour.

WILL ANY OF THIS BE ENACTED? This bill mirrors a Senate plan approved last week. The proposal's fate remains uncertain, as the Governor has not committed to signing the bill. Its fate is tied to that of the economic development proposal also passed by the House last night. If the Governor finds the legislature's trimmed-back economic development proposal to be insufficient, he probably won't swallow a tax plan that has verly little support in his party. Nor will the Republicans swallow the Governor's ideal economic development plan without significant tax changes.

Here is most recent version of the income tax bill available on the legislature's web site (H. 1615, an amendment to HF 692). You have to scroll down to "DIVISION II" to get to the income tax portions of the bill.

The Senate convenes at 9:00 this morning, when they will presumably iron out any differences they have with the house. We will follow the situation today and post updates as they become available. You can follow the action at the General Assembly's website.

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GRASSLEY SEEKS TO BOOST CHILD CREDIT FOR LOW-INCOME TAXPAYERS

June 03, 2003

The new tax bill includes a $400 increase in the child tax credit, which will be mailed to taxpayers starting next month. A provision that would make the credit "refundable" to some taxpayers was dropped in the final bill negotiations, making it unavailable to some taxpayers who had no federal income tax (a "refundable" credit allows taxpayers to get a refund even if they have no tax liability and no withholding or estimated tax paid in).

This omission has triggered criticism by opponents of the tax bill. Senator Grassley, Chairman of the Senate Finance Committee, is attempting to reverse the omission.

The Grassley proposal would also make the $1,000 credit permanent (it reverts to $500 in 2010), at a considerable increase in the "cost" to the government. Some have criticized this as an attempt to push through a larger tax increase under cover of helping low-income taxpayers. Senator Grassley says, in effect, that that's not a bug in the program; its a feature:

"Maybe I'm trying to take advantage of a political uproar to get as much permanence as I can and be as expansive as I can."

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RATE TABLE CORRECTION

June 02, 2003

An error in the married filing jointly rate table under the new tax law has been corrected. We apologize for the error.

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