Tax Update Blog: September 2003 Archives

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GOOD STUFF ON CASH BALANCE PLANS AT BENEFITS BLOG

September 26, 2003

The Benefits Blog has good coverage of the controversy over "Cash Balance" plans this week, along with other interesting stuff. You might want to start at the top and just scroll down.

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DRIVING AIN'T FARMING, SAYS TAX COURT

September 25, 2003

While they worked for software giant Oracle Corporation, Thomas and Susan Truskowsky had interests other than computers. They bought a farm about 99 miles from their home and raised Limousin cattle.

Like some other part-time farmers, they didn't make money every year. In 1996 and 1997 they deducted tax losses from their cattle operations. The IRS had other ideas.

The "passive activity" rules prevent taxpayers from deducting losses from activities in which they fail to "materially participate." The Truskowski's said they met the tax law's material participation requirements in two ways:

- They participated in the activity more than 500 hours each year, and
- They participated more than 100 hours, and more than anyone else.

The Tax Court found that they reached these thresholds by including the 99-mile drive to the farm in their participation hours - 296 driving hours in 1996 and 244 in 1997. According to the court, those hours don't count: "Commuting is an inherently personal activity and as such does not constitute 'work' in connection with a trade or business."

The result? Additional taxes of $17,656 for 1996 and $19,849 for 1997. The only consolation is that the "passive losses" disallowed carry forward to to offset farming income in later years.

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NEW LAW TIP - BUY IT NEW

September 25, 2003

The 2003 Tax Act allows taxpayers to deduct up to 50% of the cost of most fixed assets that would otherwise be capitalized and depreciated. The remaining 50% is depreciated under the normal rules.

This special deduction - "bonus" depreciation - expires after 2004. Bonus depreciation only applies to "first use," or new, property. If you are counting on the 50% deduction, make sure that you are buying "new" assets.

Example: A taxpayer must choose between a $1,000,000 "new" machine and a $750,000 "used" machine. The machines have a five-year tax life.

The "new" machine generates $600,000 of deductions in the first year: a $500,000 "bonus" depreciation deduction and a $100,000 regular depreciation deduction (1/5 of it's remaining cost). The "used" machine generates $150,000 deduction in the first year (1/5 of $750,000).

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GRASSLEY PROPOSES MANUFACTURING, AG SPECIAL DEDUCTION

September 24, 2003

Nine Percent Off!

That's the substance of a new tax break for manufacturers proposed last week by Senator Charles Grassley, Finance Committee Chairman, and Max Baucus, ranking Democrat on the committee. The plan would allow corporations a deduction of 9 percent of taxable income attributable to production activities.

The bill, known as the "JOBS" bill for reasons we will explain shortly, is the Finance Committee's response to threats of sanctions by the World Trade Organization. The WTO some time ago determined that the "Extraterritorial Income exclusion" and "Foreign Sales Corporation" rules for U.S. exporters are illegal export subsidies. The JOBS bill repeals the ETI exclusion and FSC rules while modifying several foreign tax rules. The nine-percent deduction is designed to make up for the loss of the ETI/FSC benefits.

NOT JUST FOR EXPORTERS - OR FOR FACTORIES

While the JOBS deduction is part of a bill designed to replace a manufacturing export subsidy, it has no requirement that production be exported. Nor does it require the use of a "factory" as normally understood; exports of software and agricultural products also qualify for the JOBS nine-percent deduction.

The bill appears designed to overcome the objections to the two contending ETI repeal bills that have been in play until now. The bill proposed by House Ways and Means Committee Chairman Thomas had been criticized for benefiting manufacturers only in a relatively narrow taxable income range, and for including a variety of seemingly unrelated tax breaks that made it a significant revenue loser. The "Crane-Rangel" ETI repeal bill had been criticized for failing to benefit S corporations and for not providing more tax relief.

The deduction would be based on taxable income from production, based on direct costs and "allocated" indirect costs.

WHAT WON'T QUALIFY?

The JOBS bill excludes a number of produced items from its benefits:

- "consumable property that is sold, leased, or licensed by the taxpayer as an integral part of the provision of services." That means we can't qualify as producers by sending tax returns overseas.

-oil and gas;

-electricity;

-water supplied by pipeline to the consumer;

-any unprocessed timber which is softwood;

-utility services,

- Any "tape, recording, book, magazine, newspaper, or similar property the market for which is primarily topical or otherwise essentially transitory in nature." Fortunately, the Tax Update is timeless. Unfortunately, we don't sell it.

WHEN WOULD THIS TAKE EFFECT?

The JOBS bill would phase in the nine-percent deduction starting in 2004, with a one percent deduction; the deduction would be 2% in 2005; 3% in 2006; 6% in 2007 and 2008; and 9% thereafter. It would phase out the ETI/FSC rules by 2007.

WHY NOT PARTNERSHIPS?

The bill excludes producers that operate as partnerships, such as limited liability companies. This creates an anomaly in the tax law; few provisions apply to S corporations and C corporations, but not partnerships. Individuals with LLC interests might be able to get around such problems by holding their manufacturing LLC interests in an S corporation. This is a common structure in Iowa, where S corporation shareholders get a break related to out-of-state sales that is unavailable to partners.

WHY "JOBS"?

The bill continues the questionable trend towards giving tax proposals catchy acronyms. JOBS is short for "Jumpstart Our Business Strength." The title may be a reaction to the unpronouncable and vaguely disreputable-sounding JGTRRA passed earlier this year.

UPDATE: Tax Analysts says insiders are sceptical that an ETI repeal will pass this year.

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OCTOBER 2003 AFRs ARE OUT

September 22, 2003

The IRS has issued (Rev. Rul. 2003-107) the minimum interest rates for loans made in October 2003:

Short Term (demand loans and loans with terms of 1-3 years): 1.68%
Mid-Term (loans from 3-9 years): 3.65%
Long-Term (over 9 years): 5.23%

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

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FINANCE COMMITTEE APPROVES BILL TO PREVENT USE OF NEW LIFE INSURANCE POLICIES TO FUND EXECUTIVE RETIREMENT PLANS

September 18, 2003

If the Senate Finance Committee has its way, corporate life insurance policies purchased starting today will lose much of their allure as a way to fund executive retirement plans.

According to Tax Analysts, a provision passed yesterday by the Committee makes death benefits on corporate-owned life insurance policies taxable if the insured employee has not worked for the company in the year preceding death. Death benefits used to purchase the employee's interest in the company would remain tax-exempt. These provisions would apply to policies purchased after September 17, 2003.

The tax exemption for death benefits is important to the economics of life insurance policies. If the provision survives to be passed by the full Senate and is eventually signed into law, businesses looking to use life insurance to fund executive retirement plans will find their task to be much more complex. Life policies under the new rules would function much like annuities, with policy earnings tax-deferred until maturity.

While insurance proceeds would become taxable to corporations under this bill, they would remain tax-free to other beneficiaries, such as family members of the insured.

SEPTEMBER 18 EFFECTIVE DATE: WHAT TO DO?

The provision has a long way to go before it becomes law; it would have to be approved by the full Senate and the House of Representatives.

Still, the September 18 effective date is a red flag for companies considering new policies. Corporations looking at new policies on executives - especially single-premium arrangements - should pause to evaluate this legislation before proceeding.

The September 18 effective date grandfathers existing policies, so no action is required for arrangements already in place. Taxpayers considering any policy changes should make sure that they don't endanger their ability to qualify under this grandfather clause.

We will link to the bill text as it becomes available.

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NEW LAW TIP: BEWARE AMT

September 16, 2003

We know that every cloud has a silver lining. Of course, every shiny silver lining has a dark cloud, too. The recent tax law is no exception.

Many taxpayers now dazzled by the bright shiny lining of the reduced individual tax rates of the 2003 tax law will face the dark cloud of alternative minimum tax next April. As we've noted before, AMT looms for more and more taxpayers.

The AMT is a shadow tax system that lurks alongside the regular income tax. It has only two rates - 26% and 28%; a generous exemption; and fewer deductions. If AMT exceeds the regular tax, the AMT applies. For most taxpayers, the biggest regular tax deduction missing from the AMT systems is the deduction for state and local taxes.

LOWER RATES, BUT FEWER DEDUCTIONS

In 2002, when the top individual rate was 38.6%, there was a 10.6% difference between the top regular rate and the top AMT rate. Now, there is only a 7% difference, making it easier to slip into AMT. The tax law increased the AMT exemptions for 2003 and 2004 to help alleviate this, but the exemption - like so many features of the tax law - is phased out at certain income levels. For example, the $59,000 AMT exemption for married taxpayers begins to phase out as income exceeds $150,000.

Iowans with taxable incomes from around $150,000 to $500,000 will find it very difficult to avoid AMT this year; it some cases, it will be impossible. It will be especially difficult for taxpayers with large amounts of dividends and capital gain income. These items are taxed at the same 15% federal top rate for AMT as for regular tax, but Iowa taxes them at the same rate as ordinary income. A 15% tax without a deduction for state and local taxes can exceed a 15% tax with such deductions in a hurry.

WHAT TO DO?

Taxpayers need to be especially careful with their year-end planning this year. Typical strategies, such as paying property taxes and state income taxes before year-end, can backfire when AMT applies. Taxpayers should project their income and carefully evaluate any year-end strategies with AMT in mind.

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NO FISH STORY - COURT ALLOWS DEDUCTION FOR EMPLOYEE TRIPS TO CANADA

September 15, 2003

The 8th Circuit Court of Appeals has struck a blow for fishing-minded businessmen - or maybe for business-minded fishermen. Reversing a district court, a three-judge panel held today that Townsend Industries may deduct its expenses for employee fishing outings held in 1996 and 1997.

The tax law imposes special hurdles on deductions for fun and food, as the district court noted that Townsend needed to show that:

(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.”

The 8th Circuit said the U.S District Court for Southern Iowa erred in disallowing the expenses.

IT WASN'T JUST THE FISH

Townsend Industries is an important Central Iowa manufacturer of offset printing equipment. Townsend Industries' Canadian fishing trips were apparently a high point of the corporate year. Only employees and sales representatives were invited - no spouses or kids allowed. The trips featured a dinner keynoted by presentations by the company president and CEO. The employees were on their own the rest of the time. The 8th Circuit panel decided it was reasonable to conclude from the evidence that a bunch of folks with no real connection to one another except their work could, when thrown together in the wilderness, be reasonably expected to discuss...work.

The panel highlighted several specific examples where discussions on the trips led to new products or production practices. The court also noted that "...such was the pace of life at the Townsend plant that one employee in the parts department indicated that the fishing trip was one rare opportunity that he had to have a reasoned conversation with his supervisor about their work."

CAN I DEDUCT MY FISHING TRIPS?

Don't count on it. The 8th Circuit panel took pains to distinguish the Townsend trips from undeserving junkets. The panel cited cases involving Super Bowl weekend trips with families, boating outings, and hunting lodges expenses as examples of "bad" food and fun costs. The panel commented:

We pause to note that our decision does not stand for the proposition that in all cases in which a corporation sponsors hunting, fishing, or other trips to "luxury" vacation spots that the sponsoring corporation can avoid including the per-employee cost of the trip in its employees' wages merely by presenting testimony relating to business allegedly conducted during the sojourn. A district court should be suspicious of oral, non-contemporaneous evidence provided in such cases ... and it may well be that in most cases the cost of these trips would amount to income taxable to each employee.

SYMPATHY IS NICE, BUT VICTORY IS NICER

When it disallowed the entertainment deduction, the District Court made an unusual comment in 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.

As much as it might have found those words comforting, Townsend probably found the 8th Circuit's views much more enjoyable:
... in the case at bar, we have little trouble concluding that Townsend Industries presented adequate evidence to substantiate its business purpose. Though we have reached this conclusion as a matter of law, even if "business purpose" were to be treated as a question of fact, we are satisfied the nature and quantity of the evidence presented could compel no reasonable conclusion other than that Townsend had a bona fide business purpose for its 1996 and 1997 trips.

THE MORAL?

It may be difficult to get a tax deduction for a company fishing outing, but if you have the right facts, and you're willing to fight a long court battle, it's not impossible.

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THE POULAN-WEEDEATER LINCOLN'S TOMB?

September 09, 2003

Taking a cue from sports sponsorships, Illinois is looking to private sponsorships and naming rights to public facilities to help erase its state budget deficit.

This may trigger a bidding war that could lead to naming rights for popular projects. Imagine, if you will, the Princess Casino Meigs Field Reconstruction Project, or the Libertyville Drivers License Center, Sponsored by Mega Truck Drivers School - Results Guaranteed! At least it would make it legal.

Fortunately, the naming rights for the "Roth" IRA were locked up long ago...

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NEW LAW TIP: WATCH YOUR HOLDING PERIODS FOR DIVIDENDS

September 08, 2003

The 2003 Tax Act lowered the top rate for dividends to 15%, effective starting January 1, 2003. One feature of the new law will cost active traders the benefit of this lower rate.

The new law denies the lower rate for stocks that have not been held for over 60 days of the 120-day period beginning 60 days before the ex-dividend date of the stock. For preferred stock, the holding period is 90 days in a 180-day period.

EXAMPLE: Sally Shortterm buys 100 shares of Endrun company on December 20 , 2003 for $100. Endrun goes ex-dividend on December 21 with a $2 per share distribution, which is paid December 23. Sally sells the stock on December 24 for $98. The $2,000 dividend will not be eligible for the 15% top rate; it will instead be taxed at Sally's ordinary income rates, up to 35%.

Why? The value of a stock includes anticipated dividends. All else being equal, the value of a stock goes down by the amount of the dividend on the day the stock goes ex-dividend (the person who holds the stock when it goes ex-dividend received the dividend, even if she sells the stock before the dividend is paid). The 60-day rule discourages a taxpayer from attempting to get a 15% dividend at the cost of a short-term loss on the sale. Short term losses provide a tax benefit at ordinary rates (to 35%) to the extent of short-term gains, plus $3,000.

Without the 60-day rule, Sally would pay $300 in tax on her $2,000 dividend while reducing her taxes by $700 with her $2,000 short-term capital loss.

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LOOKING IN THE WRONG PLACES

September 02, 2003

Tax Updates are preserved for posterity on the Roth & Company website. Our website hosting service gives us lots of information about how people get to the Tax Updates on the web. Many of our visitors arrive via Google or other search engines, and our hosting service lists the searches they used to get here.

Some searchers had to be disappointed. Two of the more popular searches that led to the Tax Update web site were "ring around the rosey" and "pigs get fat, hogs get slaughtered." While we probably failed to give the folks that made these searches the information they wanted, we can imagine what they were searching for - pork production tips, maybe?

One search request has left us baffled: "roth or spongers or engender or demander or tables." Maybe someone thinks Roth & Company is a bunch of spongers, which will engender someone to hire a demander to pound on tables to stop us from cadging free drinks. Shame on them!

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