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Tax Update Blog: July 2010 Archives

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The tax legislation rolling train wreck

July 30, 2010

The Congressional Summer Recess looms, and the state of the tax law remains a mess. The Estate Tax is gone for this year, but will return with a vengeance January 1 absent new legislation. The small business tax bill to extend bonus depreciation seems to be snagged ($link). There is no action in sight to extend the 70-odd expiring provisions that would have been enacted with the now-defunct attempt to apply self-employment tax to many small S corporations. The "AMT patch" to keep 20 million or so new taxpayers from being hit this year by alternatative minimum tax isn't even on the radar. And the granddaddy of expiring provisions, the 2001 Bush-era tax cuts, seem to be hurtling to their doom at year-end with the encouragement of the Obama Administration.

Rarely have so many pieces of the tax law been up in the air. Without great confidence, I offer my predictions:

- An AMT patch will patch in the run-up to the elections, along with some sort of "small business" relief, including (probably) extended bonus depreciation.
- A lame-duck Congress will pass extender legislation
- Some sort of extension of parts of the Bush tax cuts will pass, but the top rate will still rise to 39.6%. The dividend and capital gain rate will be held to 20%.
- Congress will deadlock on the estate tax, and we'll start 2011 with a $1 million lifetime exemption and a 55% top rate.

Howard Gleckman at TaxVox offers his best guess:

My best guess is that, in the end, Congress will extend the Bush tax cuts for all but the highest earners. And it will probably do so for a year or two. But after watching Congress fail to address the expiring estate tax last year, no outcome would shock me.

Me neither.

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The tax credit program was a scam. Can we still have our tax credits?

July 30, 2010

You have to be a real optimist to take this argument to the Tax Court:

Petitioners testified that the owners of the Income Tax Office showed them legal documentation indicating that the FNS tax credit was a legal tax credit or investment designed to assist taxpayers and tax preparers. They were told that if they invested an initial amount, they would be entitled to 20 percent of the credit that they were to receive from the Internal Revenue Service. At the time petitioners were unaware that the scheme was a sham, but they now admit that they have been victims of a fraudulent scheme. Petitioners further stipulated that the promoters of the scheme did not own landfills and that the landfills they allegedly invested in did not produce any alternative fuels entitling them to the FNS credits.

OK, so we were scammed. We didn't own the property that was supposed to generate the alternative fuel credits. Nobody generated any alternative fuels. Can we have our credits now?

No:

The Court deplores the fraud perpetrated on petitioners and sympathizes with the situation in which they find themselves. The stipulated facts, however, establish that petitioners are not entitled to the FNS tax credits and that the related adjustments in the notices of deficiency are correct.

Imagine that.

Cite: Xiang, T.C. Summary Opinion 2010-105

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Sometimes a quest comes to a bad end

July 30, 2010

Pinnacle Quest International had all of the trappings of a successful multi-level marketing operation. They organized big conferences in resort destinations, and even sponsored a week-long Mediteranean cruise. But rather than selling household cleaners or nutrition supplements, they offered a more risky product line:

In 2007 PQI hosted a 400-person Q3 conference aboard the Celebrity Cruise Line ship Galaxy, promoting a smorgasbord of tax fraud at sea. Ports of call during the May 14-21 Mediterranean cruise included Rome, Italy; Piraeus, Greece; Kusadasi, Turkey; Santorini, Greece; and Mykonos, Greece. Sherry Peel Jackson spoke about her frivolous tax-avoidance arguments at this Q3 conference just a few weeks after her April 13, 2007 federal indictment in the Northern District of Georgia for willful failure to file federal incoe tax returns.

The Pinnacle Quest has reached a bad end. From a Justice Department press release:

On March 31, 2010, a federal jury returned guilty verdicts against eight people, following a month-long trial in Pensacola, Fla., involving the promotion of fraudulent schemes through Pinnacle Quest International, also known as PQI and Quest International.

Arnold Ray Manansala of Renton, Wash., was sentenced to 12 years in prison for conspiracy to defraud the United States and to commit wire fraud, and conspiracy to commit money laundering. Dover Eugene Perry, also of Renton, was sentenced to 10 years in prison for conspiracy to defraud the United States and to commit wire fraud, and conspiracy to commit money laundering. Michael Guy Leonard of Troy, N.Y., was sentenced to nine years and one month in prison for conspiracy to defraud the United States and to commit wire fraud, and conspiracy to commit money laundering. Mark Daniel Leitner of Fairport, N.Y., was sentenced to five years in prison for conspiracy to defraud the United States and to commit wire fraud.

The appearance of prosperity makes it easier to believe in a tax scheme. After all, would a scam be offering such a nice cruise? Unfortunately, a nice boat doesn't make a crazy scam work. How crazy?

According to the evidence presented during trial, PQI was an umbrella organization for numerous vendors of tax and credit card debt elimination scams. Some of the PQI vendors, such as Southern Oregon Resource Center for Education (SORCE), sold bogus theories and strategies for tax evasion. For fees starting at $10,000, SORCE assisted its customers in the creation of a series of sham business entities in the United States and Panama. Other tax-related PQI vendors denied the legitimacy of the income tax system on various theories and provided customers with a "reliance defense" that consisted of a paper trail of frivolous correspondence which a client could allegedly use as evidence of good faith if the client were prosecuted.

No matter how nice the boat or the hotel room is, if it looks too good to be true, it probably is.

Previous coverage:

Questing after pinnacles
JUSTICE DEPARTMENT GOES AFTER 'TAX DEFIERS'

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'Freedom and Privacy Committee' may need a new name

July 30, 2010

fandp.jpg

A boise man whose "Freedom and Privacy Committee" promoted illegal tax avoidance schemes will be doing without freedom and privacy for awhile. Joseph Saladino was sentenced Wednesday to five years in federal prison on federal tax charges. From Oregonlive.com:
Saladino had no legal, accounting or tax training. But he and Fuselier developed their "Claim of Right" theory, based on the premise that wages and income from self-employment is not taxable. Along with Mungovan and the colorful Bendshadler, who wore a kilt to the courtroom for the duration of his trial, Saladino and Fusilier promoted the Claim of Right theory nationwide via the U.S. mail, the Internet and live seminars.

The Freedom and Privacy Committee was enjoined from giving tax advice in 2005. Things apparently went downhill from there, but as committee web site asked in a Harry Potter typeface, "who needs freedom and privacy?"

Mr. Bendshadler, the kilt-wearer, will be sentenced separately. We'll learn whether the sentencing judge is leg man.

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Don't toy with the judge. Even through kinesis.

July 29, 2010

Willie was a busy taxpayer. While working full-time as a computer analyst for the City of Houston, he also had a busy real estate business on the side. How busy? The Tax Court reports (all emphasis mine):

On petitioner's mileage log the entry for "business miles driven" typically exceeds 100 miles per day and occasionally is over 200 miles per day. For every Monday through Friday throughout the year petitioner listed 60 commuting miles; these miles were included on the log even for those days that petitioner admitted were holidays for his City of Houston position.

The IRS took issue with Willie's deductions for business use of his car. The taxpayer tried to explain:

On their 2004 return, petitioners claimed deductions for car and truck expenses of $16,177.50 and $19,162.50 for two separate vehicles. Petitioners contend that these vehicles were used solely for business and not for any personal purpose (other than commuting) such as going to church or to the grocery store. According to petitioner, "anytime you're moving, you're actually in business". So, for example, "when you drive to the grocery store, you will transact business." In this regard, when asked by the Court what part of the grocery store was most conducive to conducting his business, petitioner replied as follows:


MR. MOORE: I would say the meat section, where they have the chips and all that good stuff. That's where people stop, and the fruit section; that's where I, you know -- and if you're an agent and people know you're an agent, they will stop you and you will -- you know, just have a conversation with them. If they're in the store and you pass a [business] card out.

THE COURT: I mean, do you wear a sign that says, I'm an agent, and stop them --

MR. MOORE: No. This is only the people that know you, not strangers. You know, this would be individuals who live in the same community you live in and may have wanted to talk to you but haven't seen you. When they get to chance to see you -- it might be a church member, you know, a deacon at the church * * *.

You never know when you'll run into a customer, true enough, but that failed to satisfy the Tax Court:

We find petitioner's theorem regarding the transmutation of nondeductible personal expenses into deductible business expenses through kinesis to be so fundamentally flawed that we reject it without further discussion, and we move on to a consideration of the proffered mileage logs.

The mileage logs are, of course, the bedrock of petitioners' case. Unfortunately for petitioners, we are unable to accept those logs at face value because we are not convinced that they reliably record petitioners' use of their automobiles. By way of example, we point to the following.

Petitioner's mileage log claimed commuting miles for several days that were holidays for his full-time position with the City of Houston. In addition, petitioner stated that "my commuting miles include occasional * * * personal use"; however, petitioner's log shows the same 60 commuting miles for each entry Monday through Friday.

Petitioner also stated that some personal miles were included in business miles because, as previously quoted, "any time you are moving, you're actually in business". Although petitioner stated that he worked every day of the year, the log for his vehicle is missing entries for several days; nevertheless, the ending odometer reading from the last entry before the skipped day or days is the same as the beginning odometer reading of the next entry. Petitioner argued that the log is not "incorrect", but he did admit that there are some days on which "there might have been an error on the log."

Things worked out badly for the taxpayer:

Undoubtedly, petitioners used their vehicles for business purposes during the year in issue. However, we are unable to find that petitioners' mileage logs are sufficiently credible to accept them at face value, as we are convinced that petitioners both overstated deductible business miles and understated nondeductible commuting and personal miles. Thus, we conclude that petitioners' mileage logs are not adequate records, within the meaning of section 274(d) and the regulations thereunder, of mileage expenses and that petitioners have failed to provide other corroborative evidence sufficient to establish that they have met the requirements of that section.

The bottom line: additional taxes of $11, 299.99, plus a 20% penalty for the understatement and a penalty for filing the return late in the first place.

The Moral? If the Tax Court thinks you aren't being straight with them, they may not meet you half-way. Here the judge gave the IRS everything it asked for. If he had felt the taxpayer was being honest, he could have used the parts of the mileage log he though were reliable. Don't try to chump the judge.

Hat tip: Roger McEowen.

Cite: Moore, T.C. Summary Opinion 2010-102

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Boat: a hole in the ocean in which to pour money

July 29, 2010

So John Kerry is going to pay use $500,000 in Massachussetts tax on the boat he moored in Rhode Island to avoid paying $500,000 in Massachussetts use tax. While it's normal and healthy to mock politicians in almost all circumstances, I like this thoughful take:

No one is ever likely to mistake me for the president of the John F. Kerry Fan Club. I worked hard to prevent Kerry's election to the Senate in 1984, I have voted faithfully for his opponents ever since, and when he ran for president in 2004 I was impolite enough to describe him as a "tedious blister."

But I didn't join in the big horselaugh that everyone had at Kerry's expense after learning that he had avoided nearly half a million dollars in Massachusetts sales and excise taxes by keeping his new yacht tied up in Rhode Island. And I'm not gloating over his decision yesterday to put a stop to the media feeding frenzy by voluntarily sending the Department of Revenue a check for $500,000, "whether owed or not."

...

What was the point of browbeating Kerry into paying higher taxes? Or rubbing his nose in his own history of laments about "tax-cuts-for-the-rich" and how "abusing offshore tax loopholes is wrong"? It would have been far better to seize the moment to make Kerry see that by arranging to enjoy his yacht without paying the Bay State's onerous taxes, he was acting not badly or selfishly, but rationally. Maybe Kerry could finally have absorbed the fundamental economic reality that human beings respond to incentives -- and when taxes are too high, taxpayers and their money have an incentive to go elsewhere. Even fabulously rich taxpayers like Kerry and his wife.

(Hat tip: TaxProf)

I don't know many taxpayers who would pass up a $500,000 tax savings. If a politician uses a legal tax break, it at least shows some understanding of the tax law; they have to start somewhere. It doesn't make sense to make somebody compute taxes in a way other than what the tax law prescribes. Where would you stop?

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A Prius driving backwards?

July 29, 2010

Andrew Mitchell explains what a "reverse hybrid" is in "Hybrid Entities and Reverse Hybrid Entities."

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Where's George?

July 29, 2010

20100729-1.jpgForbes Magazine reports that George Washington was the wealthiest President. For his day, the Father of the Country was incredibly wealthy, owning immense acreage in Virginia and on the frontier (largely in current Pennsylvania and Ohio), as well as a profitable and, for its day, state-of-the-art, farming operation.

Yet all of his wealth couldn't buy George:

- A car.
- A refrigerator
- An electric light
- Air conditioning
- Central heating
- A hot shower
- A computer
- A radio or television
- Medical care that today would have cured his fatal final illness.
- A telephone
- Vegetables out-of-season
- Even the crummiest dial-up internet connection
- An airplane ride

You get the idea. In so many ways almost everybody in the U.S. is vastly richer than even the wealthiest men of 210 years ago. While he might have been hugely wealthy for his day, he did without things even the poor take for granted in our country now.

Hat Tip: Kay Bell and the TaxProf.


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Is the Iowa tax system a great deal?

July 28, 2010

If you want some depressing insight as to why Iowa has the fifth-worst business tax environment in the country, you might start with a strange column by Sioux City state senator Steve Warnstadt:

We’ve all heard for years how Iowa’s business tax climate is bad. What if some of what we “know” isn’t quite true?

Only large, publicly traded corporations pay corporate income taxes in Iowa. Their taxes are based solely on the sales of their products sold in Iowa. That is, income made by selling outside of Iowa is tax-free. Large manufacturers who sell outside of Iowa find that to be a great advantage.

That's a good example of "knowing" something that is not true right there. It's definitely not true that "Only large, publicly traded corporations pay corporate income taxes in Iowa." In fact, they are very likely to pay very low taxes in Iowa. The primary victims of Iowa's highest-in-the-nation corporation tax are Iowa businesses that, by historical accident, are locked into a C corporation structure, and who do most of their selling in-state. This includes taxpayers with large LIFO inventories or with complicated shareholder structures. It also includes a lot of farms that incorporated in the 1970s when it seemed like a good idea, and who are now stuck with their structure.

Senator Warnstadt then repeats a common assertion:

Finally, Iowa corporations are eligible for various tax credits, some of which are refundable. The most prominent is the research activities credit. Companies that conduct research and development in Iowa get a refundable state income tax credit. If the credit is more than what they owe the state, these corporations actually get a check from the state. How’s that for a “horrible” business environment?

It's a sweet deal for those corporations who are lucky enough to qualify for a refundable credit, and for those with the lobbyists or connections to qualify for the credits. Sadly, that's only a small portion of businesses. Most businesses have to pay extra taxes so the lucky and the well-lobbied get their refundable credits. That means it's not so sweet a deal for most of us.

The result is that corporations, large and small, are taxed on a relatively small amount of income. Iowa’s rate may be high, but it applies to relatively little income, making actual taxes paid comparatively small.

That's pretty much the definition of a badly-designed system -- punishingly high rates that generate little revenue.

To the extent it has any internal logic at all, Iowa's tax system is designed to lure big companies with tax breaks. It's very poorly designed for businesses to grow from the bottom up. That's why Iowa always rates poorly in developing new businesses -- the ones that create new industries and new jobs. But politicians like the current system because it enables them to show up a ribbon-cutting for some wind-turbine plant bribed into the state with tax credits. The guy who is trying to build the next Google in his den doesn't do much in the way of photo opportunities.

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So the singles bars are full of charitably-minded men?

July 28, 2010

The Tax Court rejects a tax incentive for an activity that has gone on for a long time without government support. TaxGrrrl has the details.

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Summer Buzzing

July 28, 2010

Robert D Flach rounds up the tax blog world.

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Son-of-Boss taxpayers: no straws left to grasp?

July 28, 2010

The only court decision upholding a "Son-of-Boss" tax shelter has been reversed on appeal. Things look bleak for the basis-shifting shelters of the 1990s tax shelter frenzy. Linda Beale has more.

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It's not just luck

July 27, 2010

Christopher Bergin at Tax.com:

When talking about the rich, Treasury Secretary Geithner and President Obama refer to them as "fortunate," insinuating -- if not just stating it outright -- that the rich are lucky. That's why they're rich. This is a point of view I 'd expect from a couple of liberal arts college professors, not from those in charge.

I'm all for a progressive income tax system. And I'm all for a strong estate tax for the idle rich. But the people I know who are well-off work hard for their money. They worked hard in school and worked hard in business. They took risks, which weren't backed by government safety nets. They created things. And, as they rose, they learned that there are some in this country who like to demonize success -- even fear it.

There's a saying that I'm fond of: Trying to blow out somebody's candle won't make yours burn any brighter. I'm fully aware of the growing gap in this country between the haves and the have-nots. But building class warfare by arguing that the land of opportunity has changed into the land of the fortunate few is not the answer. The tone at the top matters.

My client base is made up of of people that are "rich" by Geithner standards. They are small business operators who have achieved a little success in their S corporations and partnerships, generating enough taxable income to put themselves in the top tax bracket. They have had some luck, or at least not catastrophic bad luck, but as a rule they also work very hard. Many have taken huge chances, and some lost almost everything before finally achieving some success.

For these clients, the 1040 is also the business return, because the business income passes through to their schedule E via a K-1. Many of these people only take enough cash out of their businesses to pay their taxes, plowing their remaining cash into growth and debt reduction. When taxes on "the rich" increase next year, it's not a matter of getting by with a smaller yacht for these clients. It's a matter of sending money to the government that would otherwise pay down debt or grow the business. It's sad that somebody with as much power as Tim Geithner has a world view that seems to come out of a comic book.

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Oops!

July 27, 2010

Among the tax exempt entities in Iowa that has failed to file its tax forms for three years, and therefore needs to take action by October 15 to retain its tax-exempt status:

"Internal Revenue Service Employees Fund, PO Box 1337, Des Moines, IA 50305-1337" (Page 58 of the Iowa list, via alert reader Jay).

Heh.

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Sometimes a lease is really just a lease

July 27, 2010

20100727-1.jpgLabels can be dangerous. Many "lease" deals are really sales for tax purposes. If you "lease" a copier and can buy the copier for $1 at the end of the lease, the tax law says it's a sale; that means you capitalize and depreciate the real purchase price of the copier (or take a Section 179 deduction), and you deduct the "financing fees" as interest.

But sometimes a lease is just a lease, as an Idaho couple learned yesterday in Tax Court. The Idahoans leased a 2004 Ford Expediton truck for $607.06 over a 48-month lease. When they filed their return, though, they claimed a $28,749 Section 179 deduction, treating the lease as a financed purchase. The IRS thought it was a lease, and the Tax Court agreed (my emphasis):

The term of the lease was less than the useful life of the truck. The record does not establish the truck's precise useful life, but the fact that the parties expected it to have a residual value of $17,262 (approximately 39.5 percent of the truck's gross capitalized cost) indicates that the truck would not reach its salvage value at the conclusion of the lease. The contract was not an open-end lease requiring petitioners to compensate Dan Wiebold for any unanticipated depreciation at the conclusion of the lease, and petitioners were required to pay a nominal $395 termination fee regardless of the truck's actual residual value. The contract did not confer title to the truck on petitioners. Petitioners could acquire title only if they exercised their option to purchase the truck. The option price of $17,612 was not a nominal amount because it exceeded the truck's estimated residual value and represented approximately 40.3 percent of the truck's gross capitalized cost. Thus, at the time the contract was signed, there was no certainty that petitioners would exercise the option.

In addition to the factors that the court points out, watch for recipricol options. If the "lessor" has an option to buy the asset for a given price, and the "lessee" has a put option to the lessee for the same price, somebody will exercise the option, so the economic ownership has passed to the lessee.

Cite: Boyce, T.C. Summ. Op. 2010-100.

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A mulligan for small tax-exempts

July 27, 2010

Many tax-exempt entities unwittingly lost their tax-exempt status back in May under a 2006 tax law that revokes exemptions for charities that fail to file with the IRS for three consecutive years. Now the IRS has announced a way for smaller tax-exempts to regain their exempt status:

Two types of relief are available for small exempt organizations — a filing extension for the smallest organizations required to file Form 990-N, Electronic Notice (e-Postcard) , and a voluntary compliance program (VCP) for small organizations eligible to file Form 990-EZ, Short Form Return of Organization Exempt From Income Tax.

Small organizations required to file Form 990-N simply need to go to the IRS website [link], supply the eight information items called for on the form, and electronically file it by Oct. 15. That will bring them back into compliance.

Under the VCP, tax-exempt organizations eligible to file Form 990-EZ must file their delinquent annual information returns by Oct. 15 and pay a compliance fee. Details about the VCP are on the IRS website, along with frequently asked questions.

The relief announced today is not available to larger organizations required to file the Form 990 or to private foundations that file the Form 990-PF.

The IRS has a list of known organizations that need to take advantage of this break to retain their exempt status. The
list for Iowa organizations is here.
More coverage from TaxGrrrl.

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IRS issues applicable federal rates (AFR) for August 2010

July 27, 2010

The IRS has issued (Rev. Rul. 2010-19) the minimum required interest rates for loans made in August 2010:

-Short Term (demand loans and loans with terms of up to 3 years): 0.53%

-Mid-Term (loans from 3-9 years): 2.18%

-Long-Term (over 9 years): 3.79%

The Long-term tax-exempt rate for Section 382 ownership changes in August 2010 is 4.01%.

Historical AFRs are available at the "links" page at www.rothcpa.com. You can also click here for the rates for prior months as reported in the Tax Update.

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IRS defies courts on trust passive losses

July 27, 2010

Roger McEowen:

When a government agency is told that its litigating position has “no support within the plain meaning of the statute” and “subverts common sense,” the agency has a responsibility either to appeal the court’s decision or develop reasonable regulations rather than continue maintaining its judicially-rejected position.

It would sure be handy if taxpayers could get away with ignoring court decisions that go against them.

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Selling Downtown Des Moines, one traffic ticket at a time.

July 26, 2010

20100726-1.jpgThe next few years may be tough for downtown Des Moines. Many thousands of square feet of downtown space will become vacant as Wellmark and Aviva move into new space, while struggling Wells Fargo lays off employees by the hundreds.

Well, relax. The Des Moines city council has a cunning plan to make Downtown an attractive place to commute to. How? By setting up speeding cameras on I-235! Just to make downtown even more attractive, they will also set up red-light cameras. Nothing makes somebody want to commute downtown like a $65 ticket for going 66 on an empty highway after working late during tax season, or a $65 ticket for not quite stopping when turning right on red at an empty intersection on the way to that $65 speeding ticket.

Of course, the police say it's not about the money -- it's about safety. If they were serious about that, they would use the one tried-and-true way to make intersections safer: extending yellow-light times. But that doesn't raise any revenue, so look for the abominable cameras to show up next year.

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Appeals Court doesn't read Morse Code

July 26, 2010

Minnesota farmer Kevin Morse wasn't satisfied with his tax preparer. The guy he hired to prepare his returns for the years 1996-2000 said he owed $142,000 on $448,000 of taxable income. Rather than file those returns, he began working with Joseph Saladino. Longtime readers will remember that Mr. Saladino has long been crossways with the IRS, culminating in a conviction on tax charges in 2009.

This worked out badly for Mr. Morse, who was convicted of tax-related charges after filing returns reporting no taxable income from his Minnesota farm. The Eighth Circuit Court of Appeals last week upheld Mr. Morse's conviction. It seems that the appeals court felt that Mr. Morse should have known better (emphasis added):

Testimony from IRS agents, a banker, farmers who rented farmland from Morse, others in the farming industry, and Morse himself, combined with the tax returns and Morse's 1999 conviction of filing false tax returns, established that Morse knowingly and significantly underreported his income on his tax returns. Importantly, the jury heard evidence that Morse knew from his 1999 conviction that he had to be truthful when he filed these five tax returns. Viewing the evidence in the light most favorable to the government, the evidence shows that Morse voluntarily and intentionally violated this duty. Specifically, the jury learned that Morse was a farmer with farm income who rented out some of his land for rental income. The testimony of Morse and Urbanski provided sufficient evidence that Morse knew that he received farm and rental income and that the returns he filed did not reflect this income.

One conviction normally gets the point across.

Cite: U.S. v. Morse, CA-8, No. 08-3425

Prior coverage here.

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It's not just tax cuts 'for the rich' that expire December 31.

July 26, 2010

The Bush tax cuts expire at the end of this year. While it's accepted wisdom in some circles that the 2001 tax cuts benefited only "the rich," it's just not so. In fact, the Bush tax cuts removed many lower-income folks from the tax rolls entirely.

Congress has made no headway in extending the 2001 tax cuts. If Congress fails to act:

- The top tax rate increases to 39.6%, from the current 35%.
- The top rate for capital gains increases from 15% to 20%.
- The top rate on dividends goes from 15% to 39.6%.

But it's not just high earners that will be affected. The Tax Foundation has opened a wonderful new page, mytaxburden.org, that allows you to calculate your tax if the Bush tax cuts expire. An $80,000 single wage earner, for example, will see a $1,502 increase in his 2011 taxes if the 2001 tax cuts expire.

But with record budget deficits, maybe a tax increase is just what the economy needs. Well, maybe not. Two economists have recently studied the issue:

This paper investigates the impact of tax changes on economic activity. We use the narrative record, such as presidential speeches and Congressional reports, to identify the size, timing, and principal motivation for all major postwar tax policy actions. This analysis allows us to separate legislated changes into those taken for reasons related to prospective economic conditions and those taken for more exogenous reasons. The behavior of output following these more exogenous changes indicates that tax increases are highly contractionary. The effects are strongly significant, highly robust, and much larger than those obtained using broader measures of tax changes.

Well, that's probably the conclusion of some right-wing nutcases, right? Yes, if you consider the Chair of the President's Council of Economic Advisors a right-winger nutter. (hat tip: TaxProf).

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Are you a 'customer' when somebody gives you something?

July 26, 2010

TaxGrrrl passes on a strange survey result:

The Michigan Business School’s American Customer Satisfaction Index included Facebook in its regular survey of consumer satisfaction with companies this year. The results weren’t pretty. Facebook pulled a rank of 64 out of 100, which puts it in the bottom 5% of all private sector companies. What other companies pulled scores that low? Not even the IRS – their e-filers ranked them higher overall than Facebook.

Let's see: Facebook provides a service that nobody has to use or pay for. It puts you in contact with long-lost friends and folks with common interests. If you don't like it,you can avoid using Facebook easily just by not using Facebook. In contrast, the IRS takes your money, and they'll put you in jail if you don't pay up. The only "service" the IRS offers is too take money from some people and give it to others. And the IRS ranks higher? Their survey sample must have been overweighted on earned-income tax credit recipients and ethanol producers.

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Is extreme remodeling a charitable contribution?

July 23, 2010

Sometimes remodeling just isn't enough. To get the house of your dreams, it may be easier to just level the house and start over. It's not arson if you let the local fire department burn down the house for practice -- but is it a charitable deduction?

It isn't for an Ohio man. James and Lori Hendrix worked out a deal with his local fire department to let them fire up the old house, clearing the way for a new one. While their tax advisor didn't tell them they would get a deduction, they gave it a shot anyway, deducting what they believed to be the fair value of the house as a charitable contribution to the fire department.

Now it's not clear that they could have gotten a deduction for having the local fire department do the "tear-down" under the best of circumstances -- as this TaxProf Blog post shows, the issue is not settled. But these weren't the best of circumstances. The taxpayer blew any chance at a deduction by failing to properly document the donation on their tax return.

The tax law has a list of formalistic requirements you must follow to deduct a donation of property valued at more than $5,000. These include, among other things, a "qualified appraisal" and a properly-completed Form 8283. The Ohioans tripped up here, according to the district court opinion:

...the appraisal submitted by Plaintiffs does not contain the expected date of contribution, the terms of the agreement between Plaintiffs and the city, the qualification of Plaintiffs' appraiser (including Ann Ciardelli's background, experience, education, and any membership in professional appraisal associations), and the required statement that the appraisal was prepared for income tax purposes. Defendant's [the IRS] evaluation of the appraisal's deficiencies is accurate. See Doc. # 23-4. In fact, in addition to failing to contain any of the identified, specifically required information, one provision of the appraisal arguably disavows by omission that the appraisal was prepared for income tax purposes.

The taxpayer asked the judge to allow the deduction anyway under the doctrine of "substantial compliance." No luck:

Assuming arguendo that the doctrine indeed could apply in such taxpayer actions, the Court finds that the appraisal at issue wholly lacks even a modicum of content in critical areas to say that it substantially complies with numerous statutory and regulation mandates. The substantial compliance doctrine is not a substitute for missing entire categories of content; rather, it is at most a means of accepting a nearly complete effort that has simply fallen short in regard to minor procedural errors or relatively unimportant clerical oversights.

The IRS isn't crazy about charitable deductions for authorized arson, but the taxpayers made it easy for them here. Whenever you donate appreciated property (other than publicly-traded securities) to charity, be sure to follow the IRS property donation rules carefully. Burning your house may or may not be a good idea, but letting a deduction go up in smoke is always a tragedy.

Cite: Hendrix, USDC - SD Ohio, Case No. 2:09-cv-132.


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Unemployment Extension passes without extenders, small professional S corporation tax

July 23, 2010

Congress finally figured out how to pass an unemployment benefits extension bill without larding it up with special interest subsidies or new taxes. The President has signed a version of HR 4213 that passed Congress without either a new tax on small professional S corporations or a new tax on "carried interests."

Congratulations to all of you small professional S corproation shareholders who spoke out on this issue.

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How the Tax Update spent its vacation

July 22, 2010

Interesting part here. Regular programming resumes tomorrow.

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Let them eat canapes

July 22, 2010

Your Tax Update correspondent even now is winging his way back from his secret undisclosed location. Until he returns, we are rerunning some of his favorite items. This one first appeared August 24, 2009, less than a month before the Iowa Film Office Scandal broke.

20090824-1.jpgSo what if the state faces a billion-dollar budget shortfall. Never mind that the state still hasn't finished paying for the 2008 floods, or that schools are having to choose between math and music. Des Moines Register Columnist Rekha Basu has more urgent uses for your tax money: swell parties.

Ms. Basu realizes that Iowa's $77 million subsidy for filmmakers has critics:

But the tax credit has its detractors on the Iowa Legislature and among some who work with vulnerable populations. They fear it drains revenues from services.

But they'd feel differently if they were cool enough to make the A-list:

But some benefits can't just be measured on a dollar-for-dollar basis. The movies provide employment to local actors, construction crews, artists, caterers, drivers and a host of others. They expose non-Iowans to what the state has to offer. More intangible is the benefit of interactions in a state that can be cut off from the trends and centers of power. Not to mention the excitement factor. We've relied on caucuses every four years to bring action and celebrities to town. Now, sightings are anytime, any place.

Saturday, "The Experiment" had a wrap party downtown. Brody and Whitaker were there, mingling and posing for pictures. Frank Meeink was there. The Iowan who may have inspired the 1998 "American History X" has an acting role. Deb Cosgrove, the nurse, was there. She's been tending to the medical needs of the film's luminaries. Casey Gradischnig, local multi-media designer, was there. He's been working for Whitaker.

And if you don't get invited to A-list parties, maybe you can get a temporary job as a driver when your employer flees to South Dakota to get away from the nation's 7th-worst business tax environment.

Ms. Basu throws in a clincher argument:

One way to look at this: It's creating a niche for Iowa, just as companies do when they move call services to India. And for once, we're not on the losing end of the outsourcing.

Of course India doesn't have to pay half the salaries of call-center workers with tax money. But then India doesn't get the sweet movie-star parties.

Flickr image courtesy Geoff604's photostream.

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Harold Hill Gulls the House

July 21, 2010

While the Tax Update continues on vacation, your correspondent is rerunning this item to show that Iowa's Film Credit program was a bad idea long before it collapsed last year. This item ran on April 11, 2007.

hh44.jpgLike rubes rushing the patent medicine wagon, the Iowa House almost unanimously voted for a rich special interest giveaway for the film industry yesterday. By a 95-1 margin the House approved HF 892 to provide a 50% subsidy to film projects, and then some:

- A 25% tranferable tax credit for expenditures on a film project;
- A 25% credit for investors in film projects; and
- a tax exemption for sales of goods and services to film projects.

Because the credits are transferable, the filmmakers can sell them to finance their projects. This feature makes this tax credit a subsidy, rather than just a tax break.

If it weren't tax season, I would spend more time pointing out just how absurd this thing is. Why is this one industry - an itinerant one that leaves nothing behind but empty fast food wrappers - somehow worthy of being subsidized by every other business? The standard line about how much the filmmakers bring to the economy can be said about any business - more so, in fact, about the ones that stay here and provide permanent jobs, and who end up paying for this subsidy.

A puff piece for the bill in the local business paper says:

Supporters point out that the tax incentives do not take funds from the state, but rather lower the amount of taxes producers and investors pay.

Nonsense. From a business and accounting standpoint, this is delusional. It's like telling a businessman that if he doesn't collect his outstanding business receivables, he doesn't really lose anything. The state is out the money as surely as if it wrote a check, and the rest of us have to pay that much more to make up the difference.

The bill now looks like it will surely pass. Follow the progress of this and every other piece of foolish tax legislation at our 2007 Iowa Tax Legislation page.

Link: Prior Tax Update coverage.

UPDATE: The House roll call on HF 892 shows that Bruce Hunter of Des Moines is the representative who stood alone for the taxpayers on this one.

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Don’t Get Too Anxious to Stuff Just Anything into Your IRA

July 20, 2010

While your Tax Update correspondent continues his interminable vacation, we are running items he has run in other highly-discriminating Internet venues. This piece first appeared in Going Concern -- Accounting News for Accountants and CFOs.


Individual Retirement Accounts are a taxpayer’s dream, with constraints. The income they earn isn’t taxed until you distribute it; with a Roth IRA, it may never be taxed. It’s only natural for taxpayers to stuff anything they can that might generate income into an IRA.


That can be a terrible mistake.

Not everything is tax free in an IRA. Interest, dividends, capital gains – that stuff is fine. But beyond that things can get ugly.


Most problems arise when taxpayers try to use their IRAs to finance business ventures. Because IRAs are shirttail relatives of qualified pension and profit sharing plans, many pension plan rules, like those for prohibited transactions, bedevil IRAs, with taxes that can exceed 100%.


When an IRA owns an interest in a “passthrough” entity – usually a partnership, because most S corporations can’t have IRA shareholders – another complication arises. The tax law frowns on tax-exempt competition for taxable business. The frown takes the form of the “unrelated business income tax,” or UBIT. The UBIT hits otherwise tax-exempt entities with an income tax on their “unrelated business income.”


If an IRA owns an interest in a partnership (most LLCs are taxed as partnerships) that operates a trade or business, the IRA’s LLC income may be subject to UBIT, which applies at corporate tax rates. UBIT can also apply to an IRA if it owns an interest in mortgaged rental real estate. Some IRAs even run into UBIT by investing in publicly-traded energy partnerships, like Buckeye Partners, LP. Many states also have unrelated business income taxes.

The partnership is required to break out unrelated business taxable income and report it to the IRA. The IRA in turn must provide a tax identification number to the partnership to make it easier for the IRS to follow the UBIT to the IRA.

When an IRA is subject to UBIT, it can cause some awkward moments between the IRA investor and the trustee. Most IRA trustees want nothing to do with filing Form 990-T, the UBIT return. Of course the IRA owner doesn’t like the idea either, but it needs to be done. Having income tax in an IRA is especially ugly when it’s a Roth IRA, which normally would otherwise be tax-exempt forever, inside and out.

The threshold for filing a 990-T is “gross income” of $1,000 or more. Gross income is normally higher than taxable income – it is the IRA’s share of gross receipts less cost of goods sold, not reduced for any other expenses.

So be careful what you stuff into your IRA. Just because you can put something in there doesn’t mean you should.

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Shareholders held hostage

July 19, 2010

While your Tax Update correspondent vacations, we are running pieces written for other publications to give them a narrower readership. This item first appeared July 1, 2010, in IowaBiz.com, the Des Moines Business Record's web site for entrepreneurs.

US Supreme Court building, front elevation, st...Image via Wikipedia

Limited liability companies and S corporations are popular ways to do business in Iowa. Income of both S corporations and LLCs is only tax once; C corporations, in contrast, can be taxed twice. 

Yet the single-tax format can cause problems.  The single tax is achieved by having the business income taxed on the returns of their owners, rather than to the business itself.  Business income taxed on the return can be distributed to owners without a second tax. Most LLCs and S corporations distribute some or all of their earnings - at least enough to let their owners pay the tax on the business income.  But what if they don't?

That problem came up in a case decided yesterday by the Iowa Court of Appeals. An S corporation was owned by a family. When the mother died in 2006, her son Joseph exercised an option to purchase her shares at a formula price. The mother's Estate and Joseph couldn't agree on how the formula should work (a good story in itself), and it's taken three years (so far) to sort that out. In the meantime, the Estate has still owned the shares, and the company has remained profitable. That means the Estate has had to pay tax on its share of corporate income. 

Joseph, however, had the S corporation stop making distributions. 

So - the Estate had to pay tax on the earnings, even though it wasn't receiving any distributions.  Meanwhile, the formula price was fixed at the date of death, so the Estate wasn't getting any benefit from the income that it was paying the tax on. Or at least that's the way Joseph wanted it to work. This had the perhaps intended effect of putting pressure on the estate to settle.

The Court of Appeals of Iowa didn't let that stand.  While it sided with Joseph on how the formula should work, it wouldn't let him hold the distributions hostage (my emphasis):

The Estate specifically alleged that Joseph's decision to have the corporation stop making distributions sufficient to cover the ongoing tax liabilities breached that duty. Joseph acknowledged in his testimony that he caused DLDC to cease paying distributions. We conclude that this conduct was in bad faith, since it had the purpose and effect of forcing the Estate to bear the tax liabilities while Joseph received the corresponding profits on the Estate's shares, with no apparent justification...

Joseph engaged in bad faith and oppressive conduct, and breached the covenant of good faith and fair dealing in the buy-sell agreement, by discontinuing the longstanding practice of paying dividends during the pendency of this dispute. We agree with the Estate that the federal and state income taxes it was forced to pay on post-July 2006 profits without any distributions to pay them should be added to the compensation it receives from Joseph for its shares.

Unless this result is reversed by the Iowa Supreme Court, this case gives hope to minority owners of profitable LLCs and S corporations.  If a majority owner withholds income tax payment distributions, perhaps to force a sale, Iowa courts could well step in on behalf of the minority owners to force a payout.

But it would have been best to avoid this problem by including in the buy-sell option agreement a clause requiring a business to make distributions to cover taxes until the sale closes.

Note: Hat-tip to IowaBiz.com contributor Christine Branstad for her Twitter link to the case.


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Tax Court: Don’t Bet Your Bass on Those Hobby Losses

July 16, 2010

We are running pieces your Tax Update correspondent has written for others while he pursues his passion of stalking the rare Iowa Pleistocene snail. This item first appeared in Going Concern -- Accounting News for Accountants & CFOs.

One of the promised benefits of feminism was that both men and women would reap benefits from allowing women to achieve their potential in the workforce. And for Mr. Steve Lowe, it absolutely worked that way.

The Tax Court gives a hint at Mrs. Lowe’s achieved potential:

During the years at issue petitioner wife (Mrs. Lowe) worked full time as a “controller” for Fry Steel Co., where she has worked for over 38 years. She earned $177,219 and $184,181 in 2005 and 2006, respectively, with an additional $12,000 per year for taking notes at the board of directors meetings.

And how did that work out for Mr. Lowe?

In 2005 Mr. Lowe fished in 26 tournaments run by either American Bass, FLW Strem Series, or Western Outdoor News (WON) and reported gross income on petitioners’ Schedule C of $4,241. In 2006 Mr. Lowe fished in 15 tournaments run by those same organizations and reported $10,932 of gross income. The entry fees ranged from $280 to $825 with an additional $325 for a “coangler” amateur in FLW events.

Yes, Mrs. Lowe’s empowerment enabled her to hold down a fulfilling and well-paid job, freeing her husband to follow his dreams – to go fishing every day.

The only thing that could possibly be better than fishing every day while your wife brings home a nice paycheck is to get a tax deduction for fishing every day while your wife brings home a nice paycheck. And Mr. Lowe gave it a try, deducting $49,067 of fishing expenses in 2005. Unfortunately, he hooked a snag.

The tax law disallows losses from activities “not engaged in for profit” – the so-called “hobby loss” rules. The Tax Court summed it up (my emphasis):

Mrs. Lowe earned substantial income from her job at Fry Steel Co., and the losses from Mr. Lowe’s fishing activity resulted in substantial tax benefits. During the years at issue Mrs. Lowe earned an average of about $180,000 a year from her job, and petitioners were able to deduct an average of about $41,000 per year on their joint Federal income tax returns due to Mr. Lowe’s fishing activity losses. Mr. Lowe was not employed before the fishing activity and was able to pursue this activity because of Mrs. Lowe’s substantial income. We also note that Mr. Lowe fished for recreation and pleasure long before commencing his competitive bass fishing activity. He clearly enjoyed that activity and likely would have incurred significant fishing costs yearly for personal pleasure had he not conducted his claimed business activity.

The case illustrates some hobby loss red flags:

The activity loses money and shows no sign of doing otherwise – It’s fishing, for heavens’s sake.

The losses offset significant other income – If you would be getting the earned income credit otherwise, the IRS doesn’t invoke the hobby loss rules.

The activity is fun – If your money-losing business can be perceived as fun – like fishing, say, or playing slots – it’s that much harder to convince the IRS that you’re really in it for profit. Remember, though, that even miserable activities (like selling Amway or writing blog posts) can run afoul of the hobby loss rules.

So Mr. Lowe lost his deductions. The Tax Court waived penalties, though, and Mr. Lowe, as far as we know, still can fish every day while his wife works. Millions of red-blooded men would take that deal, even without tax deductions.

Joe Kristan is a shareholder of Roth & Company, P.C. in Des Moines, Iowa, author of the Tax Update Blog and Going Concern contributor. You can see all of his posts for GC here.

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IF TRUTH IN ADVERTISING APPLIED TO ECONOMIC DEVELOPMENT AGENCIES

July 15, 2010

It's rerun season until your Tax Update correspondent returns from summer vacation. This timeless item first appeared November 19, 2007.

News item: State approves funding for 14 businesses; 1,000 new jobs expected.

Every time the state announces how many new jobs they've "created" by bribing businesses with tax dollars extracted from other businesses, you wish they had to to cover the other side of the story. It would look something like this:

Des Moines (AP). Economic development officials today called a press conference to discuss the jobs lost this week as a result of the state's economic development activities.

"Yes, that sucking sound you hear is the sound of jobs leaving Sioux City for South Dakota," said economic development director Mike Tramontina. "Our 'bribes for business' program has had disappointing results when compared to South Dakota's 'no income tax' economic development program."

Tramontina cited the state's highest-in-the-nation 12% corporate tax rate and its 8.98% top individual rate as important causes of the job losses. "And if that weren't bad enough," said the Director, "the laws are so brutally complex here that nobody wants to hear about our dandy tax credits."

Tramontina also pointed out that when some businesses are bribed, other businesses suffer. "Sure, I can bribe somebody to open a bar in a rehabbed building. But then I have to find somebody else to bribe when the unsubsidized bar down the street closes because of the state-sponsored competition. So we create new jobs at the new bar, but we lose the jobs at the old one. It's like treading water."

He also pointed out that when one business gets a property tax exemption, all of the neighboring businesses have to take up the slack to pay for services for the new one. "Sombody always says 'the heck with it' and moves to South Dakota or someplace warm"

Tramontina also set aside a part of his press conference to address the dozens of businesses that don't even consider moving to Iowa. "Sure, I can brag about some obscure movie being made in Burlington. But we get far less than our share of businesses because of our tax structure. Businesses aren't stupid. They know that if they come here for the bribes, we'll be taxing them soon enough to bribe somebody else. It's like a girl who sees a married guy trying to pick her up in a bar by buying her drinks with his wife's money. If she's smart, she'll know that soon enough he'd dump her for some other new girl, while she pays the tab."

Tramontina finished his conference by outlining proposals to cement Iowa's standing as the worst state for new businesses. He boasted how proposals to tax corporations on a "combined" basis will apply the highest corporate tax rate not only to corporations doing business in Iowa, but also to their corporate siblings. "That will make sure the whole corporate group stays the heck away from Iowa."

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Iowa's 10-year business sale tax break

July 14, 2010

The Tax Update is on vacation. In the meantime we are running pieces your correspondent has run in other venues. This item first appeared in IowaBiz.com, the Des Moines Business Record's blog for entrepreneurs.

Typical Iowa Farm, Muscatine County, Iowa.Image via Wikipedia

What do you need to hold for ten years?

If you run a business in Iowa and it goes well, you might be able to hang in there and stay in business for 10 years or more. If it goes really well, you might be able to sell out for a nice profit. If all that happens, you might get to cash out without paying Iowa tax on your capital gains.

Iowa has a special tax break for for capital gains of businesses when you meet two conditions:

- A 10-year holding period, and
- Ten years of material participation at the time of sale

You can qualify if you sell substantially all of the assets of the business in a single sale, or on any sale of business real estate, such as farmland.

But if you have owned the business for 10 years and you sell, do only the assets that you've held for 10 years qualify for the break? If you bought a new location seven years before the sale, will that qualify?  A newly-released letter from the Iowa Department of Revenue says it does:

The rule does not require each individual asset be held more than ten years. Since the asset was held more than one year, the deduction should have been allowed.

A few other things to keep in mind:

- Holding period rules follow federal holding period rules -- so holding periods of gifted assets, inherited assets and like-kind exchanges go back to the original purchase date.

- "Material participation" is determined under the federal "passive loss" rules.  That means for most businesses, you have to sell within five years after retirement to qualify.  A special rule allows retired farmers who have 10 years in the business to sell anytime.

- The exclusion is not available for a sale of stock or of a partnership interest, except for gains on liquidation for a corporation that has made a qualifying sale of substantially all of its assets.  

- It only applies to capital gains.  If part of your gain is from the sale of ordinary income items, like inventory, that will still be taxed by Iowa. This is another reason to pay careful attention to how you allocate your sales price.

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Closely-Held Corporations May Want to Take a Bullet Over the Pending Dividend Tax Hike

July 13, 2010

While your correspondent takes an undeserved summer vacation, we are running posts he has written for other web sites that you perhaps have missed. This post originally appeared in Going Concern -- Accounting News for Accountants & CFOs.

aj20.jpgAs a role model, Andrew Jackson has serious shortcomings, not least his penchant for genocide. But some of his policies are back in vogue, like the casual destruction of the national banking system. Taxpayers may be choosing to be like Andy in another way before the end of this year.

Jackson had the bad fortune to get crossways with Charles Dickinson, one of the best pistol shots in Tennessee, when dueling was still fashionable. He met his antagonist across the state line in Kentucky, where duels were legal. Jackson was serious about this one, so he decided to take all the time he needed to do Dickinson in. Given Dickinson’s marksmanship, that meant accepting a bullet. Sure enough, Dickinson’s shot hit home:

The bullet struck him in the chest, where it shattered two ribs and settled in to stay, festering, for the next 39 years. Slowly he lifted his left arm and placed it across his coat front, teeth clenched. “Great God! Have I missed him?” cried Dickinson. Dismayed, he stepped back a pace and was ordered to return to stand on his mark.

Blood ran into our hero’s shoes. He raised his pistol and took aim. The hammer stuck at half cock. Coolly he drew it back, aimed again, and fired. Dickinson fell, the bullet having passed clear through him, and died shortly afterward.

Taxpayers owning C corporation stock might also want to take a bullet, figuratively speaking, this year. That’s because the tax rate on dividends will either leap or soar in 2011.

The increase in the dividend rate is a consequence of the scheduled expiration of the 2001 Bush tax cuts after this year. Prior to the Bush administration, dividends were taxed as ordinary income. As dividends are distributions of corporate income already taxed at a corporate rate as high as 35%, that meant a combined rate of 57.75%. The Bush tax cuts tied the dividend rate to the capital gain rate, now 15%.

When the Bush tax cuts expire, the capital gain rate is set to return to 20%. But without Congressional action, dividends will again be taxed as ordinary income. Given the size of the deficit, the poisonous election-year political atmosphere, and that the President promised to hold the dividend rate to 20%, it’s likely that dividends will be taxed as ordinary income in 2011. That would means a 164% increase the top dividend rate.

But wait, there’s more! Starting in 2013, Obamacare will tack another 3.8% to the top rate on investment income, resulting in a top dividend rate of of 43.4%, making the total tax increase over 189%.

This makes it tempting to take the bullet – a big 2010 dividend out of a closely-held C corporation. It will be especially attractive for shareholders who lack the ability to suck out corporate cash using the usual tricks of shareholder bonuses or rent payments.

Yes, it means taking a bullet. Taking dividends out of closely-held corporations breaks the rules of the C corporation tax planning crib book. Taxpayers go to elaborate lengths to avoid taking income before they have to. But a 189% tax increase might be enough to make some taxpayers take the bullet, like Andy, for the greater good.

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It doesn't have to be this way

July 12, 2010

While the Tax Update takes a summer vacation, we are running posts that your correspondent has written for other sites. This post originally appeared at IowaBiz.com, the Des Moines Business Record blog for entrepreneurs.

Iowa has the 46th-best best state tax environment for business in the country.  That's a nice way of saying it has one of the worst.  High rates leavened with complex loopholes for the well-lobbied make our tax environment  poisonous for entrepreneurs.

It's easy to imagine a better tax world: the world of the Quick and Dirty Iowa Tax Reform.  It looks like this:

1. Eliminate the Corporation income tax. The Iowa corporation income tax has the highest stated rate in the country, and one of the highest effective rates. The only reason it doesn't destroy Iowa's economy altogether is that it is so riddled with loopholes that collections are very low - well below 5 percent of the state budget. Yet it is a very expensive tax to administer and to comply with. Eliminating the tax would send a powerful message to companies looking for a place to invest for the long term.

2. Reduce the Iowa individual income tax to 4 percent or less. 3.99 percent would be much more attractive to entrepreneurs and executives considering Iowa locations. It would bring our rate decisively below all of the border states except for Illinois and South Dakota. Only a low rate will enable Iowans to give up the large number of special breaks that make compliance and tax administration expensive.

3. Strip down the Iowa tax law. To get the rate down to this level, Iowa will need to strip its tax law of a host of politically-motivated tax breaks. These include, among others:

- All economic development tax credits - ethanol, films, research and development, "targeted" jobs and the like, they all should go. Low rates are more important than any of these, all of which serve primarily to fund the well-connected.

- The deduction for Federal income taxes. If the rates are low enough, the deduction doesn't matter nearly as much. If its built into the rates, you protect poorly advised taxpayers who have a big once-in-a-lifetime income item - say, from selling a business - and losing the value of the deduction by paying the tax when it is due, rather than prepaying in the year of sale.

- The exclusion for ten-year capital gains.

- The credits for tuition funds, community foundations, and the like.

- The special pension and tuition breaks for old folks.

Any breaks for poor folks should be in the form of a generous
low-income exemption. Old folks with low income aren't necessarily more
worthy than younger folks. In fact they often are much more wealthy
than their younger counterparts.

Just because a break isn't mentioned here doesn't mean I want to keep it.

4. Make federal taxable income the starting point for Iowa taxable income. If you use federal AGI as the starting point, you can achieve even greater simplification and lower the rates further. Unmodified AGI as a tax base can create grossly unfair results, but it if you allow a deduction for gambling losses and Schedule A investment interest, you get a decent base. Federal changes in income computation would automatically be incorporated in Iowa's tax code, absent a vote of the legislature otherwise. It also makes Iowa's tax forms potentially postcard-sized.

5. Make Iowa's tax forms into a reconciliation format, starting with Federal taxable income. Have lines to back out federal Treasury income, which the state can’t tax. If Iowa chooses to tax muni bond income, have a line for that. Have one last line for all (any) other addbacks and subtractions, which would feed from separate detail schedules.

6. The most difficult issue is taxation of S corporations. I would allow S corporations to elect to be Iowa C corporations and make Iowans taxable on distributions from the corporation as if they were C corporations. Electing corporations would have to report distributions to Iowa shareholders to the state, and the shareholders would be taxed as if the distributions were taxable dividends; otherwise electing corporations would pay no tax on Iowa-source income. Iowans owning Non-electing S corporations would be taxed in Iowa on all their S corporation income. This would achieve near-parity between Iowa C and S corporations.

For every business that loses a chance to shake down the state for new credits, a hundred will be better off for not having to deal with high rates and complexity. When the legislature sits down this month to tweak the tax system to pay for their spending, ask them for a tax system that benefits you instead of the out-of-staters with the expensive lobbyists.

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L.A. Dodgers Owners Use Loss Carryforwards; So Now They’re Tax Cheats?

July 09, 2010

Your Tax Update correspondent is on summer vacation. We are re-running items he has run on other sites until his return. This post originally appeared at Going Concern -- Accounting News for Accountants and CFOs.

Stipulated: the L.A. Dodgers are evil. Not seventh-circle evil like the Mets or the White Sox, but evil enough. And we’ll assume, for sake of argument, that their owner, Frank McCourt, bathes in Kruggerands while sipping puppies blended with 50-year old single-malt scotch.

That still doesn’t make him a tax cheat.


So why this lame L.A. Times column from Frank Hiltzik?

To everyone who claims that our wealthiest citizens pay more than their fair share of income taxes and we should cut them a break because they’re the ones who, you know, create jobs in our economy, I have four words for you:

Frank and Jamie McCourt.

The McCourts, who own the Los Angeles Dodgers (so she says; he says he’s the owner and she’s not), jointly pocketed income totaling $108 million from 2004 through 2009, according to documents Jamie McCourt recently filed in the couple’s divorce case in Los Angeles County Superior Court.

On that sum, they paid zero federal and state income tax.

They made $108 million and paid no federal income tax? Why might that be?

According to Jamie, the McCourts employed two mechanisms to live tax-free. One was to claim enormous tax losses from their business, which was mostly commercial real estate before they bought the Dodgers. These could be carried forward, offsetting income year after year until they were finally netted out.

So let’s get this straight: they made $108 million by losing $109 million? It must be magic! No?

“…Jamie’s accountant states in a court document that some is due to depreciation, which is a way of accounting for wear and tear on a property.”

So real estate losses are non-cash funny money? The tax law stretches commercial real estate deductions out over 39 years now, so real estate isn’t a great tax shelter. Sure, you can deduct commercial mortgage interest, but you can’t deduct principal on mortgage payments. So even in real estate, the McCourts’ $130 million tax loss carryforward isn’t a symptom of prosperity.

Let’s consider another exotic possibility: maybe they really lost money. Mr. McCourt’s day job is in commercial real estate. How has that been doing lately?

But Hiltzik seems to think tax loss carryforwards are some kind of cheaters game, or maybe even a status symbol, like a Mercedes or a private jet:

“Jamie’s documents say that in 2008 the net loss carry-forward from previous years was $109 million — in other words, the McCourts could have earned that much without paying a penny of income tax.”

Imagine of a world without loss carryforwards (I think you can!). You start a business and you lose $2 million in Year 1. In Year 2 things turn around and you make back $1 million. Without loss carryforwards, as a 35%-rate taxpayer you would pay $350,000 in Year two, even though the business is still $1 million in the hole. That’s an effective rate of >infinity%.

Perhaps Mr. McCourt is prosperous in spite of his loss carryforwards. Maybe his real estate has held its value, unlike everybody else’s. Maybe he’s even running personal expenses through his business (though Leona Helmsley learned that the IRS looks for that). But even a Los Angeles real estate empire can suddenly come crashing down.

Remember that maybe, just maybe, Mr. McCourt’s soon-to-be-ex-wife has a vested interest in making him look prosperous, and in making losses look like a mark of wealth. She might like some of that.

[H/t: TaxProf Blog]

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Like-kind exchanges: stay inside the lines

July 08, 2010

The Tax Update is taking a little vacation. Until we return, we are rerunning items your correspondent has posted on other websites. This item first appeared at IowaBiz.com, the Des Moines Business Record's blog for entrepreneurs.

IRS building on Constitution Avenue in Washing...Image via Wikipedia

People who make a bundle selling a piece of real estate tend to feel good about real estate investments.  They want to put that money right back into real estate.  The tax law goes pretty far to accommodate such folks.  Section 1031, the "like-kind exchange" section of the tax code, allows taxpayers who follow its rules to roll the proceeds of an investment real estate sale into a new property.  Done right, the gain is deferred until the replacement property is sold.  But one little foot-fault in doing the deal can make the whole thing taxable.

The Basics.  Section 1031 allows you to exchange one property directly for another property of "like-kind" without current tax.  It also allows you to sell a property through an intermediary and roll the proceeds into a replacement property bought from a third party if you carefully follow IRS procedures.  You have 45 days from the time you sell the property to identify replacement properties and 180 days to close.

There are a lot of ways for a swap to go wrong.  Things to be careful about:

Be careful about the 45 and 180 day deadlines.  You have to identify candidate properties in writing in 45 days with your intermediary.  If you wait until day 46, you lose.  If you close on day 181, you might as well never close.

Be careful about your intermediary. One major east-coast intermediary recently went bankrupt because of poor investments of escrowed proceeds.  A Florida man recently received a 100-year prison sentence after looting the escrowed funds of intermediary companies he owned.  Make sure the intermediary is sound, and be careful that the intermediary can only hold your proceeds in the safest investments.  If the intermediary fails, you stand to lose your entire sales proceeds.

Watch out for related parties.  A Hawaii developer had the intermediary buy replacement real estate from another company controlled by the same owners.  This blew up the exchange, making a $12 million gain taxable.

Be sure your property qualifies.  Section 1031 only works when the property is both "like-kind" and "held for investment or for use in a trade or business.  While real estate is generally like kind to other real estate, partnership interests and corporate stock never qualify.  The "held" rule can trip up flippers who try to cash out of property held only briefly.  Personal-use property doesn't qualify; this rule can trip up folks who try to use Section 1031 to sell their vacation homes.  The IRS provides a handy safe harbor for folks looking to swap vacation property.

Get professional help.  Section 1031 is normally taxpayer friendly, but only if you observe the formalities.  Once careless foot-fault can wreck the whole deal.  Use an attorney who understands these things, and get your tax professional involved.

Further reading: IRS.gov, Like-Kind Exchanges Under IRC Code Section 1031

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You Don’t Like the Way I Prepared Your Return? Take Two Tylenol and Call Me in the Morning.

July 07, 2010

While the Tax Update author enjoys vacation, we are rerunning pieces your correspondent has written in other places. This post originally appeared in Going Concern -- Accounting News for Accountants and CFOs.

While the IRS is cracking down on tax preparers and proposing new rules to herd them into submission compliance, problem preparers aren’t a new problem.

Back in 1982, when the 1986 Code was just a gleam in Dan Rostenkowski’s eye, the nation’s headaches went untreated when people started dying from cyanide-tainted Tylenol. We still live with the hard-to-open containers for almost everything as a legacy of the murder spree. The killer has never been nabbed, but the tax world has supplied one suspect. The Chicago Tribune reports:

James William Lewis, a longtime suspect in the 1982 Tylenol murders, made a rare public appearance on public access television near Boston on Sunday night, hoping to promote his new self-published novel, “Poison! The Doctor’s Dilemma.”


Instead, Lewis was met with a barrage of questions from the show’s host and callers about whether he had a role in the unsolved cyanide poisonings that left seven Chicago-area residents dead, and if his novel had anything to do with the killings.

Why the suspicion?

Lewis said during the 48-minute interview that he regretted having written Tylenol’s manufacturer after the deaths, demanding $1 million to “stop the killing,” for which he was convicted of extortion.

A mistake anybody could make, especially after things have gone bad in your tax practice:

After his extortion conviction in 1983, Lewis served more than 12 years in prison. In the 1970s, Lewis was accused in Kansas City, Mo., of killing and dismembering a client of his tax-preparation business. Charges were dropped after a judge threw out most of the evidence.

That just shows how the new preparer regulations are long overdue. We can be confident that IRS Commissioner Shulman’s new preparer registration and CPE requirements — especially the two annual “ethics” hours — will keep anything like that from ever happening to a preparer today.

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Summer reruns

July 06, 2010

The Tax Update is off for an undisclosed time to undisclosed locations. In the meantime we will be running items that your correspondent has run on other sites. We will start, however, with perhaps my favorite post from this site -- timely again now that Microsoft is proceeding with its West Des Moines server farm.

LOCAL CPA FIRM VOWS TO SWALLOW PRIDE, ACCEPT $28 MILLION


In a tearful virtual press conference held at their corporate headquarters, Roth & Company spokesman Joe Kristan recanted his opposition to targeted tax breaks and vowed to accept massive government subsidies on behalf of the firm.

"We are really excited about the new Microsoft server farm. The bipartisan enthusiasm for taking money from taxpayers and giving it to selected businesses frankly moved us," said Kristan. "With Microsoft receiving tax breaks worth $40 million to create 50 jobs next year, and maybe 75 eventually, we realized that our 35-employee firm must be eligible for $28 million or so." While the Microsoft benefits are in the form of tax breaks, said Kristan, "We prefer cash. We've already created the jobs and have been doing so for years. We're willing to swallow our pride and take money for it. We could charge interest and muck up the tax law, but we're a good corporate citizen. We'll just take the money."

Kristan pointed out that it was a better deal for the state than the Microsoft server farm in a number of ways. "We're using a building that's already there. You don't have to put in roads or run fiber lines. Just write us a check. A wire transfer would be fine too."

Kristan said the firm was committed to creating "dozens, maybe hundreds of thousands of jobs" eventually -- "someday, somehow, somewhere."

The firm, which was started in 1990, plans to use the money on a number of projects. Kristan said it would be nice to have a couple of fully redundant sets of file servers for the office. "Not so much a server 'farm' as a server patio garden," he explained. The firm also plans to install a state of the art coffee maker to provide fresh brewed coffee from freshly-ground beans on demand. The remainder of the funds are expected to be used to fund energy independence, affordable health care and retirement security for the firm's owners.

"We thank Governor Culver, Senator Grassley, Congressman Boswell and Senator Gronstal for opening our eyes to the benefits of these targeted incentives," said Kristan. "We are confident that the necessary legislation will pass. All it will take is for our elected officials to give our proposal the same scrutiny they gave to the proposals by Microsoft and Google."

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One Million

July 05, 2010

While I wasn't looking, the Tax Update Sitemeter turned over 1 million visitors last Wednesday, just before noon our time.

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It was somebody from Washington -- maybe one of our friends from the Tax Foundation? -- who apparently entered the site directly, and who stopped to look at this post about Homebuyer Credit fraud.

That's more a tribute to longevity than popularity, of course, as we set up the Sitemeter in 2003 (I think), after the blog had been in business for over a year already. We hit 500,000 on April 14, 2008. To compare, the TaxProf Blog hit 1 million visitors after 19 months, and after six years of operation has hit 10 million visitors. That helps keep keep things in perspective.

Still, it's nice that you keep coming. Whether you are a regular visitor or a Google or Bing referral, I hope you find something worthwhile here. Thanks for visiting.

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If you remodel by starting over, you need to move back in

July 02, 2010

California can be complicated. A couple just wanted to remodel the Santa Barbara house they had lived in for two years, but their architect explained that new zoning rules required them to either leave the house as it was or tear it down and start over. So they brought in the bulldozers, tore down 880-square foot building on the property they had bought in 1984 for $150,000, and built a new three bedroom house.

That worked out well in the end. So well, in fact, that by the time they finished the new house, with a total investment of $591,406, they sold it for $1.1 million before even moving in.

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Flickr image courtesy alaina.buzas under Creative Commons license.

The tax law allows joint filers to exclude $500,000 in gain on the sale of a property used as a principal residence in two of the previous five years. The Santa Barbara couple took this position. The IRS had other ideas, as the Tax Court relates:

Respondent's [IRS] argument interprets the term "property" to mean, or at least include, a dwelling that was owned and occupied by the taxpayer as his "principal residence" for at least 2 of the 5 years immediately preceding the sale. Respondent urges this Court to conclude that a qualifying sale under section 121(a) is one that includes the sale of a dwelling used by the taxpayer as his principal residence. Because petitioners never resided in the new house before its sale in 2000, respondent maintains that the new house was never petitioners' principal residence.

The Tax Court yesterday sided with the IRS. In a divided opinion, the court found that the meaning of "principal residence" was unclear from the statute, at least as far as a tear-down is concerned. They looked to the legislative history and found that the new house in the same spot doesn't step into the shoes of the tear-down:

The legislative history demonstrates that Congress intended the term "principal residence" to mean the primary dwelling or house that a taxpayer occupied as his principal residence. Nothing in the legislative history indicates that Congress intended section 121 to exclude gain on the sale of property that does not include a house or other structure used by the taxpayer as his principal place of abode. Although a principal residence may include land surrounding the dwelling, the legislative history supports a conclusion that Congress intended the section 121 exclusion to apply only if the dwelling the taxpayer sells was actually used as his principal residence for the period required by section 121(a).

Life is simpler for most of us. Most municipalities don't make it worthwhile to tear down a perfectly good house, and most people who do move in once they are done. The Tax Court does raise some questions about odd fact patterns. What if the couple had been able to remodel and their 880-foot house became a 3,000 foot house -- and then they didn't move back in? Would it still be one residence, or would they have to split the price? What if they had bought an adjoining lot and then sold?

For now, the answer seems to be: move back in for awhile before you sell. This case could still be appealed, though, so stay tuned.

Cite: Gates: 135 T.C. No. 1

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How bad is the long term federal budget outlook?

July 02, 2010

Awful. And that's the optimistic scenario. TaxVox reports:

Of course, no one believes that Congress will really be that disciplined. That’s why CBO offers a second vision, in which lawmakers give in to temptation. They extend the tax cuts, patch the AMT, limit bracket creep, increase payments to Medicare docs, allow discretionary spending to rise with GDP, and turn off some of the health legislation offsets after 2020.

If policymakers give in to all those temptations, the debt skyrockets, rising from about 60% of GDP today to 185% by 2035. And that’s assuming no negative effects on the economy. As my colleagues Len Burman, Jeff Rohaly, Joe Rosenberg, and Katie Lim have pointed out, out-of-control deficits would weaken the economy by crowding out investment and driving up interest rates, so the debt-to-GDP ratio would actually grow even faster.

They certainly seem in no mood to spend less of our money.

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You pay the taxes, I'll keep the income

July 02, 2010

The Iowa Court of Appeals this week said a majority S corporation shareholder had to pay an estate for taxes it paid on corporate income during a buy-sell agreement dispute. I explain in my new post at Iowabiz.com, Shareholders held hostage.

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And you thought the Harry Potter trailer was cool

July 02, 2010

Just wait 'til you see "An introduction to the United States Tax Court: Welcome and Overview"!

Via the TaxProf.

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Tans are taxable today

July 01, 2010

The first new tax under Obamacare takes effect today: a 10% tax on indoor tanning services.

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Flickr image from Evil Erin under Creative Commons License

The providers will have to pay the tax via quarterly filings on Form 720. The IRS has posted "Nine Tips on the 10 Percent Tax on Tanning Services":

1. Businesses providing ultraviolet tanning services must collect the 10 percent excise tax at the time the customer pays for the tanning services.

2. If the customer fails to pay the excise tax, the tanning service provider is liable for the tax.

3. The tax does not apply to phototherapy services performed by a licensed medical professional on his or her premises.

4. The tax does not apply to spray-on tanning services.

5. If a payment covers charges for tanning services along with other goods and services, the other goods and services may be excluded from the tax if they are separately stated and the charges do not exceed the fair market value for those other goods and services.

6. If the customer purchases bundled services and the charges are not separately stated, the tax applies to the portion of the payment that can be reasonably attributed to the indoor tanning services.

7. The tax does not have to be paid on membership fees for certain qualified physical fitness facilities that offer indoor tanning services as an incidental service to members without a separately identifiable fee.

8. Tanning service providers must report and pay the excise tax on a quarterly basis.

9. To pay the tax, businesses must file IRS Form 720, Quarterly Federal Excise Tax Return using an Employer Identification Number assigned by the IRS. Businesses that don’t already have one can apply for an EIN online at IRS.gov.

As the summer wears on, we can look forward to rampant tax evasion:

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Flickr image courtesy mike52ad under Creative Commons license.

More IRS guidance:

IRS Issues Regulations on 10-Percent Tax on Tanning Services Effective July 1

Excise Tax on Indoor Tanning Services Frequently Asked Questions

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Filling the giant hole, $8,000 at a time

July 01, 2010

Late last night the Senate passed HR 5623, a 3-month extension of yesterday's deadline to close purchases of houses placed under contract by April 30 to qualify for the "popular" first-time homebuyer credit. The bill passed despite warnings that it invites massive backdating of paperwork to "qualify" home purchases for the $8,000 refundable credit. Every Iowa congresscritter voted to take money from all of us -- or our grandchildren -- to give $8,000 each to perhaps 2,030 Iowans and 178,000 other housing welfare recipients. The bill goes to the White House, where approval is assured.

While making sure to subsidize people who, in theory, can afford a house, the Senate did not pass an extension of unemployment benefits. Interesting priorities.

UPDATE: More from TaxGrrrl.

Related: The lingering death of the Homebuyer Credit

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Water Wings Cavalcade

July 01, 2010

As the rivers continue to rise in Des Moines, be like this couple and manage your risk of sinking at the new Cavalcade of Risk, hosted by Wenchypoo!

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Don't miss Insureblog's timely post on disaster preparedness at the Blogosphere's premier roundup of insurancae and risk-management posts.

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