Tax Update Blog: July 2004 Archives

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AMWAY AND TAXES

July 30, 2004

The Tax Court this week provided another illustrations of the tax hazards of the Amway business. The court disallowed a host of travel and other deductions for an Illinois Amway distributor under the so-called "hobby loss" rules, on the grounds that the distributorship wasn't entered into for profit.

Amway distributors sell household items out of their homes. (Amway is now called "Alticor".) The court described the Amway system:

   An Amway distributor earns income by 
   selling products and recruiting new 
   downline distributors. Under Amway's 
   compensation system, a distributor earns a 
   "performance bonus" based not only on 
   the sales volume generated by the 
   distributor himself but also on the sales 
   volume generated by the distributor's 
   downline network.  Generally, distributors 
   earning large performance bonuses have 
   developed a large and broad network of 
   downline distributors.

Many Amway distributors have ended up crossways with the IRS. A quick search of a tax law database shows over 40 cases where Amway distributors have lost court fights with the IRS. The earnings pattern in the Illinois case illustrates why the IRS gets into disputes with some distributors:

   Year       Income             Expenses      Net Losses
    1996         $10            ($ 1,625)       ($ 1,615)
    1997         357             (13,177)        (12,820)
    1998         625             (17,504)        (16,879)
    1999       1,450             (17,384)        (15,934)
    2000       3,235             (23,001)        (19,766)
                _____             _______       _______ 
    Total       5,677             (72,691)       (67,014)

The consistent pattern of taxpayer defeats in Amway cases has even led one commentator to question whether Amway losses will ever clear the "hobby loss" hurdle. He cites three problems that Amway distributors have in court: "a sustained series of losses; the use of Amway losses to offset other income; and a failure to conduct the distributorship in a businesslike manner."

While such a sweeping conclusion may not be warranted, taxpayers with loss patterns like this can expect IRS trouble - especially when much of the income is from sales to themselves and the expenses are primarily travel-related. Such patterns make courts suspicious:

   Petitioners repeatedly used their Amway 
   activity as an attempt to mask obviously 
   personal expenses as deductible business 
   expenses. In effect they attempted to live a 
   deductible lifestyle. The conferences at 
   times of the year associated with vacation 
   and recreation are consistent with this 
   same mindset. Most importantly, petitioners 
   reported no significant revenue from their 
   Amway activity and no reason for them to 
   believe they ever were going to have 
   significant revenue from this activity.

The moral? If you sell Amway, your profits will need to be from the business, not from the IRS.

Cite: Ollett v. Commissioner, T.C. Summ. Op. 2004-103

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TREASURY PROVIDES COMPREHENSIVE HEALTH SAVINGS ACCOUNT GUIDANCE

July 30, 2004

The Treasury has been issuing guidance on the new Health Savings Accounts in bits and pieces since the HSA provisions became law last December. Earlier this month the IRS issued comprehensive guidance that should clear up most remaining questions about these new IRA-like savings vehicles. Using a question and answer format, IRS Notice 2004-50 answers 88 questions about HSAs.

HSA OVERVIEW

Health Savings Accounts are investment accounts that can be funded by taxpayers with "High-deductible" health insurance plans. Taxpayers with such plans can make tax-deductible contributions to the plans. Plan earnings and withdrawals are tax-free if used to pay health care expenses. Plan earnings not need for health care expenses can be withdrawn on a taxable basis under rules similar to the IRA rules.

QUESTIONS ANSWERED BY NOTICE 2004-50

The new HSA guidance makes clear that an when an employer offers employees a choice between a high-deductible plan and a "traditional" health plan, employees choosing the high-deductible plan qualify for HSAs. It confirms that employee assistance plans and prescription discount cards do not disqualify health plans from HSA coverage. It discusses "preventative care" that can be paid by the plan before the deductible is met without disqualifying the insured from HSA eligibility.

EXPENSES ARE FOREVER

The plan confirms (Q&A 39) that HSA owners can carry over expenses from year to year for later tax-free reimbursement. For example, a 40-year old taxpayer starts an HSA in August 2004. Each year he incurs $2000 in out-of-pocket health costs, so over 25 years he has incurred $50,000 in unreimbursed medical expenses. If he hasn't withdrawn any funds from his HSA for 25 years, he can withdraw up to $50,000 tax-free. The catch: he has to be able to document those old expenses.

LIFE IS EASY FOR TRUSTEES

Some trust departments have been reluctant to become HSA trustees because they don't want to monitor whether HSA withdrawals are for qualified health care. They need not worry. Not only are trustees not required to verify whether the beneficiary is making a withdrawal for qualified medical expenses, they aren't allowed to. Q&A 79 of the notice provides:

   The HSA trust or custodial agreement may 
   not contain a provision that restricts HSA
   distributions to pay or reimburse only the 
   account beneficiary’s qualified medical 
   expenses. Thus, the account beneficiary is 
   entitled to distributions for any purpose and 
   distributions may be used to pay or 
   reimburse qualified medical expenses or for 
   other nonmedical expenditures. Only the 
   account beneficiary may determine how the 
   HSA distributions will be used.

Notice 2004-50 enables taxpayers to establish HSAs with confidence about the tax effects. Employers should ask their insurance carriers about adding a high-deductible plan with their next health insurance renewal. The premiums on such plans are lower, and some employees may appreciate the opportunity to establish an HSA. Tax-deductible contributions and tax-free withdrawals are hard to beat.

HSA QUALIFICATION REVIEW

A "high-deductible" plan has to meet certain standards:

- a deductible of at least $1,000 for single coverage or $2,000 for family/joint coverage.

-The out-of-pocket maximum per year cannot exceed $5,000 for single coverage and $10,000 for family/joint coverage.

-The taxpayer cannot be covered by a non-qualifying policy for items covered by the high-deductible policy.

The contribution limits are:

-Individuals (self-only coverage): the lesser of $2,600 or the annual policy deductible

-Families: lesser of $5,150 or the annual deductible

-Taxpayers over 55 can contribute an additional $500.

-There is no phase-out for high-income taxpayers.

The BenefitsBlog has more on Notice 2004-50.

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HIGHBROW TAX POLICY DISCUSSIONS

July 27, 2004

Tax policy doesn't always have to be discussed at the elevated level you've grown accustomed to here. The Tax Prof Blog notes the new policy brief, "The Three Little Pigs Buy the White House."

   Tax Cuts are a major theme in the new 
   children's book, The Three Little Pigs Buy 
   the White House (St. Martin's Griffin, 2004). 
   In a jibe aimed at the current Administration, 
   Rummy, Dickey, and Dubya build their own 
   houses of bricks stolen from the country 
   while they build the rest of the country with 
   mud and straw, which are soon threatened 
   by the big, bad tax cuts.

No word on whether the obvious risks of child abuse charges inherent in reading about taxes at bedtime will deter conservatives from countering in kind. Possible responses:

Goldilocks and the Three Marginal Rates, by Arthur Laffer. A young girl in the woods maximizes economic activity when she settles on marginal tax rates that are "just right."

The Ant and The Grasshopper, by Buchanan and Tullock. Avaricious locust resorts to rent-seeking behavior when winter arrives.

The Goose and the Golden Egg, by Freidrich Hayek. After raising taxes on the goose to excessive levels, the state seizes the goose's means of production, ending the era of golden eggs.

Yeah, these will push "South Beach Diet" books right off the charts...

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BACK TO WORK!

July 27, 2004

Vacation's over, and our desktop is largely visible after a day of digging through the accumulated debris of two weeks off. It appears that the tax law was relatively quiet while we were away, but a few items worth mentioning made the news.

IRS STARTS PROCESSING RETURNS UNDER NEW SYSTEM

The IRS recently started processing returns using its new Customer Account Data Engine (CADE) system. Years late and millions over budget, the CADE system is the first upgrade of the IRS data processing system in about 40 years. If you just had to download the 87th security patch this year to your "Windows" operating system, you may admire the robust nature of the old IRS system, but it's time to let the remaining programmers who understand the old system finally relax and enjoy their World War I retirement benefits.

EDWARDS: TAX SHELTER GUY?

The Wall Street Journal and the New York Times did us a favor when it called Senator John Edward's S corporation law practice a "Tax Shelter." The Senator elected S corporation status for his law practice in 1995. S corporations don't generally pay tax; their income is instead reported on their owners' personal tax returns directly. As a personal injury lawyer, Senator Edwards drew a $380,000 salary and received his remaining share of the law practice income on his K-1. This added up to about $27 million before he left his practice to take his senate seat.

The "tax shelter" arises because S corporation K-1 income is not subject to self-employment tax. While Senator Edwards paid the maximum FICA tax each year, he avoided the Medicare tax of 2.9% on amounts passing through on the K-1 of what the Times called his "so-called" S corporation. The savings are said to exceed $500,000.

Why is this good for us? We have a lot of S corporation clients. Now when clients question whether we are being sufficiently agressive in our tax planning, we can say, "Hey, we put you in John Edwards' tax shelter! What more do you want?" Sure, it's pretty much bread-and-butter tax planning, but we don't have to tell people that.

ETI CONFERENCE DELAYED

Republican taxwriters delayed the conference to reconcile the House and Senate ETI repeal bills until September. This means the $100,000 Sec. 179 maximum deduction for new sport utility vehicles remains available for qualifying taxpayers awhile longer.

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TAX UPDATE SUMMER VACATION

July 07, 2004

The Tax Update is going on vacation. If you can't do without a tax fix (and who can?), you can get it at these frequently updated web sites:

-The Tax Prof Blog - a weblog by U. of Cincinnati Tax Law Professer Paul Caron.

- Mauled Again, the weblog of prolific tax professor and BNA Portfolio author James Maule.

- BenefitsBlog - an ERISA-centric weblog by B. Janell Grenier, a Philadelphia-area benefits attorney.

Or, you can revisit your favorite Tax Updates right here, or in the archives.

The Tax Update returns the last week of July.

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THE KIDS GET THE GOLD MINE, MOM GETS THE SHAFT - AND THAT'S THE WAY SHE PLANNED IT!

July 07, 2004

How's this for a deal:

1. Mom puts income-producing property in a trust.
2. Mom has no right to income or principal from the trust.
3. Mom does retain the right to swap out property in the trust for other property of equal value. Other than this power, Mom has no control over the trust.
4. While Mom gets nothing from the trust, she has to pay the tax on any income the trust earns.

Mom gets to pay the tax, the kids get the money - that's the way life works, right? Lest you think Mom is a doormat, keep in mind: Mom is always more wily than she gets credit for.

A GIFT THAT'S NOT A GIFT

Mom did this on purpose to take advantage of an anomaly between the estate tax rules and the income tax rules. While the assets of the trust are no longer in her estate for death tax purposes, she is still their owner for income tax purposes.

Mom already fully funds the $11,000 annual exclusion gifts available for each of her kids. By paying the tax on what, economically, is her childrens' income, she can, in effect give them additional gifts - gifts that are not subject to gift taxes, because they are "her" taxes for income tax purposes.

DOES THIS WORK?

Practitioners have long believed this plan works, and have acted accordingly. There remained some uncertainty, though, as the IRS was ambiguous in its reaction to these trusts.

The uncertainty disappeared yesterday when the IRS issued Rev. Rul. 2004-64. The ruling holds that this plan works, as long as Mom has no right to be reimbursed by the trust for the taxes she pays on trust income. The ruling cautions that such a reimbursement right will cause the trust assets to be included in her taxable estate at death, for trusts created after October 3, 2004

(No link is yet available to the ruling text)

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GRUMPY CARNIVAL?

July 06, 2004

This week's "Carnival of the Capitalists," a weekly summary of business-related weblog postings, is up now - although in a somewhat grouchy format.

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$4.80, $42,048 - IT'S THE THOUGHT THAT COUNTS, RIGHT?

July 06, 2004

Scary things happen at the last minute. Think of the last-minute history paper you finished at 4:30 a.m. demonstrating that George Washington was directly responsible for the Hindenberg Disaster. Or the iguana that seemed like a great last-minute anniversary present. And let's not even talk about that one tax return...

The last minute is a scary time for legislators, too. Tax Analysts brought to our notice a drafting error made on the last day of the 2004 Iowa legislative session that has brought much of Iowa's nascent wind energy industry to an abrupt halt.

The legislature passed a bill that would create a tax credit for new wind farms. To make sure the cost didn't get too high, the legislature inserted in the bill an annual cap on the amount of credit for each wind turbine. And they certainly did keep the cost down.

The cap was meant to be $3.20 per megawatt capacity - that is, based on how many megawatts a unit generates per hour. There are 8,760 hours in a year, so that should translate into a maximum annual credit of $42,048 for a typical 1.5 megawatt unit. Unfortunately for the wind industry, the bill as drafted fails to make the necessary translation of hourly capacity to annual capacity, so the maximum credit per year for a 1.5 megawatt unit is... $4.80.

According to an Associated Press story, the error has put on hold a $200 million wind farm planned for the Iowa Falls area.

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REALITY TV, GOOD AND HARD

July 05, 2004

Paul Caron at The TaxProf Blog has been pondering the taxability of benefits received by participants in "reality" TV shows. His latest installment deals with taxpayers receiving "Extreme Makeovers" on their homes.

If they combine the subsequent IRS exam with one of the "bachelor" shows, maybe it won't be so bad.

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WILL NEW JERSEY TRY TO GET AROUND HEALTH ACCOUNT RULES?

July 01, 2004

The Treasury recently waived some of the requirements of the Health Savings Account rules until 2006, allowing HSAs to be set up in states with rules mandating low-deductible or no-deductible coverage, at least for some health conditions. These state provisions conflict with the requirement that HSAs be used with high-deductible health insurance plans.

The waiver seemed to us to open the door to mischief:

   Various state rules require coverage with 
   lower deductibles for certain conditions. 
   For example, Kansas until recently required
   that mental and nervous conditions be 
   covered for 100 percent of the first $100 of 
   expenses, 80 percent of the next $100, and 
   50 percent of the next $1,640.
   Such provisions were enacted because they
   had a political constituency. To avoid 
   confronting interest groups, legislators are 
   likely to instead pressure Treasury to 
   extend the Notice 2004-43 waiver.  The 
   slogans are easy to imagine: "The IRS wants 
   to take our high-risk mentally ill off their 
   medications!"

We didn't have to wait long. The BenefitsBlog reports that that the political pressure option appears already to be preferred in New Jersey, based on this report in the New Jersey Star Ledger:

   But changing New Jersey's lead poisoning 
   law may not be the answer, according to 
   State Sen. Joseph Vitale (D-Woodbridge), 
   chairman of the Senate Health and Human 
   Services Committee. 

   Vitale said he is in favor of HSAs, which he 
   said "could be an important tool for providing
   coverage to the uninsured."

   But rather than changing the New Jersey 
   law, Vitale said the state might consider 
   "whether New Jersey can appeal to the 
   Treasury. New Jersey is being progressive, 
   and we are trying to provide financial help 
   to people who have been exposed to lead 
   paint. I don't see why the federal government 
   would want us to revise our rules in order to 
   take advantage of the HSA."

Giving in to this pressure would inexorably turn HSAs into just another tax break, rather than a policy tool to transform health insurance into something more like, well, insurance. Most health insurance now looks more like a purchasing pool than health insurance. If auto insurance were like health insurance, we'd be filing claims with State Farm or Geico every time we had our oil changed, and the newspapers would be talking about the "crisis" in auto insurance.

Giving the responsibility for health care purchase decisions to consumers seems more likely to lead to good use of health dollars than anything a state legislature would come up with. Unfortunately, the door has been opened at least a crack for legislatures to do their thing.

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