News On The Tax Front--The latest tax news.
IRS Issues Ruling on Depreciation of Exchanged Property--How do you depreciate property acquired in a like-kind exchange? The IRS has finally publishing guidance, and it should be beneficial to most taxpayers.
S Corporations -- Husband and Wife Shareholders--There's a potential trap for husband and wife shareholders in an S corporation, but there's also an easy way around it.
Capital Gains -- Part I--There's more to the rules than the 20% and the one-year rule, especially if you own a business.
Accounting Basics -- Capital Stock -- Part I --You should know the basics and, fortunately, they're not that complicated. A must read if you do your own accounting.
Series I Savings Bonds --Introduced in 1998 for many investors they're more attractive than EE bonds and even other government and corporate bonds.
In Brief:--Tax, business, and personal finance tips.
Previously Reported In Daily Update
In a recent tip we mentioned that there are benefits to leaving an IRA to your spouse and traps if you leave an IRA to any other beneficiary in your will. In a recent letter ruling (LR 200008044) the IRS ruled that a trust that was a beneficiary of an IRA could divide an inherited IRA into four equal IRA accounts without affecting its status. Distributions on the IRA had begun before the death of the IRA owner and the minimum required distributions were calculated on the joint lives of the owner and his oldest son. Distributions from the divided accounts were to be based on the life expectancy of the son.
Two Senators have introduced a bill that would allow taxpayers who do not itemize to deduct 50% of charitable contributions in excess of $1,000. That threshold would drop to $500 after the year 2005.
If you purchase the assets of a business, you can write off intangibles such as goodwill, customer lists, etc. over 15 years. When the law was written several years ago Congress enumerated a number of intangibles. However, favorable financing wasn't among them. Favorable financing can arise when a taxpayer has assumed debt with an interest rate below market as part of the purchase of a business In recent Field Service Advice (FSA 200008018) the IRS held that such an asset was not considered by Congress and is not subject to the amortization rules.
We've mentioned that the IRS is planning a crackdown on corporate tax shelters. In a recent U.S. Court of Appeals case (ASA Investerings Parnterships, et al.; 2000-1 USTC 50,185; U.S. Court of Appeals, D.C. Circuit) the Court upheld a Tax Court ruling that a partnership in which Allied Signal invested could not be used to reduce the company's taxes. The Court found that the venture had no business purpose and neither the bank nor Allied Signal intended that a partnership actually exist. The Court held that the bank was not a partner, but merely a lender in the transaction.
The IRS is allowed to contact third-parties to get tax information for them that it cannot get directly from you. For example, it can request information from your bank or from your employer. Under a 1998 tax law change it must first provide notice to taxpayers before doing so. Last year the IRS sent out notices that, was, to say the least, controversial. In fact, the wording of the message caused a furor amongst almost all who received it. Now, the Service is going to try again. This time the language used is much less inflammatory and advises taxpayers that the information that it can disclose to third parties is limited. The notices have begun going out. The notices are clearer and the third-party letters more specialized. In addition, the notices are targeted to about 8 million taxpayers, not the 25 million targeted last year. Who can expect such a notice? Generally, the letters and notices are limited to taxpayers who have unpaid liabilities, unfiled tax returns, or resolved tax issues.
The Senate is now taking up the bill that would provide relief from the marriage penalty. The Senate version may be more generous than the House one. While passage at this early stage is still far from sure, prospects look good.
The employee-independent contractor controversy is unlikely to end soon. Whether you win or lose on the basic question, you can reduce the tax damage if you can show you're entitled to the safe harbor protection under Sec. 580 of the Revenue Act of 1978. One of the requirements is that you've got to treat similar workers consistently. In Leb's Enterprises, Inc. (2000-1 USTC 50,182; U.S. District Court, No. Dist. Ill., East. Div.) the taxpayer employed drivers for its transportation company. But, although drivers performed essentially similar functions, some were treated as employees, some as independent contractors.
At the begining of each year the IRS releases the results of the prior year's business plan, detailing which projects were accomplished and the stage of completion of those that weren't.
Transfers of property to spouses incident to a divorce escape tax. It's as if one spouse made a gift to the other spouse. However, in the case of Carol M. Read (114 TC--, No. 2) the spouses each owned stock in a corporation. The wife transferred her shares back to the corporation, not to her husband, in exchange for cash and a promissory note from the corporation. The Court found that the transfer was on behalf of her husband, and, thus, it should not be taxed.
The IRS has announced that it has adopted revised annual report/return forms (the Form 5500 Series) filed for employee pension, welfare and fringe benefit plans. The forms are being adopted concurrent with the implementation of a new computerized system to improve forms and simplify and expedite the receipt and processing of the Form 5500 Series by relying on computer scanable forms and electronic filing technologies.
Ideally, you'd like to avoid the IRS labeling any business as a passive activity. If it is, any losses can only be used to offset income from the same or another passive activity. In William Warren Kelly (T.C. Memo. 2000-32) the Tax Court sided with the IRS in holding that the taxpayer's aircraft leasing business was a passive activity despite the fact that he materially participated in the activity by spending at least 500 hours a year in the business. Remember, rental activities are generally inherently passive.
In order to claim a deduction for a dependent you generally must provide over half the support of that individual. In Emmanuel I. Nwachukwu (T.C. Memo. 2000-27) the taxpayer, who was a divorced father, was unable to show the Court that he provided such support. In addition, the Court discovered that the child did not live with the taxpayer for a majority of the year, as he had claimed.
In Emmanuel I. Nwachukwu (T.C. Memo. 2000-27) the taxpayer was denied a deduction for job search expenses. The taxpayer could not provide documentation nor could he show that the expenses were related to his trade or business. Note. The more suspicious looking the expenses, the more care you should take in documenting them and providing evidence to show the relevancy. The expenses denied here included a trip to Nigeria.
In Rev. Rul. 2000-8 the IRS presented examples of situations where employer contributions to a 401(k) plan will be considered to be elective contributions by the employee even if made pursuant to an arrangement under which a fixed percentage of an employee's compensation is contributed to the plan unless the employee affirmatively elects to receive the amount in cash. In other words, the employer can automatically deduct amounts from a newly hired employee's wages and contribute them to a 401(k) plan as long as the employee can elect out of such an arrangement.
E-filing of federal tax returns is up once again. The IRS reported that for the second week of February, e-filing of returns by individuals is up 98%, e-filing by tax professionals is up 11%. The large increase by individuals is somewhat misleading since the base is small. That growth will taper off in coming years. The IRS also reported that the average refund has increased by about 8%.
A bill has passed the House Ways and Means Committee that would repeal the rule that a senior who has earned income has to repay $1 of social security for every $3 of income over the $17,000 earnings limit (2000 amount). Since the bill has the support of both Republicans and Democrats, passage looks encouraging.
You can get a charitable deduction for property you contribute to a recognized charity. However, you can only deduct the full value if the property is free of debt. If the property is "encumbered" your deduction is limited to the amount in excess of the debt. In Maxine Goodman, et al. (2000-1 USTC 50,162; U.S. District Court, So. Dist. Fla.) the taxpayer contributed a partnership interest and related liabilities. The Court held that the transaction was part charitable contribution and part capital gain.
Amounts received as a settlement for personal injury are generally excludable from income; amounts received to compensate a former employee for lost wages are taxable. In Alain and Monique Massot (T.C. Memo. 2000-24) the taxpayer was able to convince the Tax Court that a portion of the settlement he received from a wrongful termination suit represented damages for personal injury. Caution. This is a tricky area, and taxpayer's win here was unusual. Read the case in full before taking a position.
In T.D. 8865 the IRS announced that it was adopting the new regulations relating to the amortization of intangibles under Sec. 197 and amendments to certain regulations under Sec. 167.
An individual operating as a sole proprietorship cannot take a business deduction for health insurance or a medical reimbursement plan. (Up to 60% of the health insurance may be deductible on the front page of Form 1040.) However, if you employ your spouse, he or she can be covered by the plan and you can deduct those expenses on Schedule C. That's what the taxpayers in Walter W. Wollenburg and Leola Wollenburg (2000-1 USTC 50,156; U.S. District Court, Dist. Neb.) attempted to do. However, the Court found that the spouse received benefits before the formal adoption of the plan. The Court held that the payment made to her had to be included in her income.
The House has passed a bill that would eliminate the marriage penalty, with a number of Democrats also voting for the measure. The bill would increase the standard deduction for married couples to twice that for single individuals. It would also increase the income limit for married couples in the 15% bracket to twice the amount for single individuals. However, because of the cost of the bill, $180 billion over 10 years, the White House has predicted the measure would not survive the Senate. If it does, it's likely the President will veto it. While this bill may not see its way to become law, it increases the chances for relief for married couples this year.
The IRS has released the following new or updated publications:
If you want to claim the benefits of a corporation, you've got to actually use the corporation for business, not just pass funds through the corporate bank account. In Joseph J. House (T.C. Memo. 2000-22) the Tax Court disregarded the taxpayer's corporation, finding it to be a sham. It attributed all the income to the taxpayer.
IRS Issues Ruling on Depreciation of Exchanged Property
The law allows a taxpayer to avoid recognition of gain on a like-kind exchange of property. For example, you trade in a truck you've used in the business for a new truck. Were it not for the like-kind exchange rules, the trade-in could result in a taxable gain or loss. When you acquire property in a like-kind exchange part of the acquired property takes on the basis of the old property.
Example--Madison Inc. purchased a truck for $20,000 several years ago. It took a total of $10,400 of depreciation on the truck and is now trading it for a new truck. In addition to the trade-in, Madison will pay cash of $14,000 at the time of purchase. Madison's adjusted basis in the old truck is $9,600 ($20,000 purchase price less $10,400 in depreciation). Add that to the $14,000 in cash paid and the total tax basis in the new truck is $23,600.
There's no gain or loss on the transaction and Madison's basis in the new truck is made up in part from the adjusted basis of the old truck and part from the cash paid. Note that it doesn't make any difference what the selling price of the new truck is. (Things get trickier if you receive some unlike property, including cash, and in some other situations.)
Up until now there has been no guidance on how to depreciate the acquired property. Most taxpayers assumed that you start over, just as if you purchased the property new. In Notice 2000- 4 the IRS provided guidance on what to do. The acquired property should be depreciated over the remaining recovery period of, and using the same depreciation method and convention as that of the exchanged property. Any excess of the basis in the acquired property over the adjusted basis in the exchanged or involuntarily converted property is treated as newly purchased property. An example should make it clear.
Example--Assume the facts are the same as in the example above. Madison took 2 years' of depreciation on the old truck. Since the truck is 5-year property, Madison will continue to depreciate the $20,000 cost of the original truck over the next 3 years (actually 4, since 5-year property is depreciated over 6 years, with a half year's depreciation in the first and last year). The additional basis of $14,000 that arose from the cash paid for the new truck will be depreciated over 5 years, just as if Madison had purchased a new truck for $14,000.
While the new rules add some complexity to depreciation computations, they will allow for faster depreciation of assets than if depreciation was restarted on the new asset. Taxpayers must follow these new rules for MACRS property (generally property acquired after 1986) placed in service on or after January 3, 2000 in a like-kind exchange or as a result of an involuntary conversion (e.g., casualty loss, condemnation, etc.).
For property placed in service before January 3, 2000 in a like-kind exchange or involuntary conversion, the IRS will allow a taxpayer to continue to use its present method of depreciating the acquired property. However, a taxpayer presently treating the acquired property as newly purchased may change to treating the property under the rules of this notice, provided the property has been treated by the taxpayer as acquired in a like- kind exchange or involuntary conversion and the change is made for the first or second taxable year ending after January 3, 2000.
If you're using a computer program, you may have to get an update. If you're planning on switching accounting methods for previously exchanged property, you must follow the automatic change in accounting method provisions of Rev. Proc. 99-49.
S Corporations -- Husband and Wife Shareholders
It's not unusual for a husband and wife to each own shares in the same S corporation. For some purposes the holdings are aggregated (e.g., if you own 5% and your wife owns 5%, her shares are attributed to you, and vice versa; thus, you're deemed to own 10%). However, for purposes of computing your basis and amount at risk for taking losses, that's not true. Your basis is computed independently of your spouse's.
That can be a problem if the corporation has losses and only one of you have loaned the corporation money. You may find that your share of the losses may be deductible, but not your spouse's.
Example--You and your spouse each own 50% of Madison Inc. At the beginning of 2000, your basis is $5,000; your wife's is the same. Madison has not done well and you (but not your wife) loans the corporation $50,000. For the year Madison has a $40,000 loss. Your share of the loss is $20,000 and fully deductible since your amount at risk before the loss was $55,000 ($5,000 in stock and $50,000 in debt). Your spouse's share of the loss is also $20,000, but only $5,000 (the amount of her basis) is deductible. The remaining $15,000 isn't lost, but can be carried forward and used in a later year.
Whether that's good or bad depends on the situation. If you're in a low tax bracket (as is likely if the business isn't doing well) in the current year those losses may be saving taxes at only 15% or 28%. Why not save them for the another year when you might be in the 31% or higher bracket? There are two downsides. The first is the risk that you may never be able to fully use the losses because of other reasons. The second is the time value of money. A dollar of taxes saved today is better than a dollar saved next year.
What should you do if you want to take the deduction in the current year? Simply split the debt so that each of you loan the corporation equal amounts, $25,000 in this case.
The basic rules about capital gains taxes you probably know. Hold a stock, land, etc. more than a year and the gain is taxed at 20%, otherwise it's taxed at your highest tax rate--up to 39.6%. That's probably the most important rule, but there are others. And, while you don't need to know them all or the arcane details behind them, you should be familiar enough with the rules to spot a tax trap or opportunity. Here's a synopsis of some rules that are important to investors and business owners.
Holding period. Currently, there's only one holding period to worry about -- 1-year. In order to qualify for long- term gain treatment, you have to hold the asset more than one year. You begin counting on the date after the day you acquired the property. The day you disposed of the property is part of your holding period.
Example--You purchase investment property on March 2, 2000. In order to qualify for long-term treatment, you can't sell the property before March 3, 2001.
For securities traded on an established securities market, your holding period begins the day after the trade date you bought the securities and ends on the trade date you sell them.
If you acquire the property in a nontaxable transaction, your holding period will probably be longer. If you receive the asset as a gift, your holding period includes the donors; the same is true if you inherit the property; if you contribute property to a corporation, the corporation's holding period includes your holding period; if you receive the property in a like-kind exchange, your holding period includes the holding period of the property traded in.
Rates. For individuals, the tax rate on long-term gains is generally 20%. For individuals in the 15% bracket, the long-term gains rate is 10%. In the case of collectibles such as a stamp or coin collection, artwork, etc., a 28% rate applies to long-term gains.
If the asset sold is real property on which you took depreciation, any depreciation recapture is subject to tax at 25%.
Example--Several years ago you purchased land and a building for $100,000. Of the total, $20,000 was allocated to the land; $80,000 to the building. You've taken a total of $10,000 of depreciation on the building. You sell the property for $200,000, allocating $40,000 to the land and $160,000 to the building. Your gain on the land is $20,000 ($40,000 less $20,000) all taxed at 20%. Your adjusted basis in the building is only $70,000 ($80,000 cost less $10,000 in depreciation). Your total gain is $90,000 ($160,000 selling price less $70,000 adjusted basis). But of that total, $10,000 is depreciation recapture. Thus, $10,000 of the gain is taxed at 25%, the remaining $80,000 is taxed at 20%.
If the property is held by a C (regular) corporation, long- term capital gains are taxed at no more than 35%. However, that's also the highest regular rate for a corporation, so there's really no long-term capital gain benefit. Moreover, any gains in a C corporation can be taxed twice. Once as capital gains at the corporate level, and again as a dividend if distributed to the shareholders.
Tax Tip--That's one reason you should try to hold real estate and select other assets outside of a regular corporation. You can hold them either in your own name or through an LLC, partnership, or S corporation.
S corporations, partnerships, LLCs. If you do business through one of these entities, all gains and losses are passed through to the shareholders, partners, or owners and reported on their personal tax return. Generally, the partnership, S corporation, etc. pays no tax. (There is an exception for built-in gains in an S corporation. These arise when a regular corporation converts to an S corporation.) Thus, the end result is the same as if the individual held the asset in their own name. The good news is that there's no double tax as there can be in a C corporation.
Tax Tip--Keep the passthrough rules in mind when doing your tax planning. You could find an S corporation in which you own an interest sold an asset for a big gain. You might want to take capital losses to offset it, or anticipate a big cash outflow when you file your tax return next April. Conversely, if the passthrough entity will generate losses, you might want to generate offsetting gains.
For tax years beginning after December 31, 2000 the old capital gain rules and rates continue to apply, but there's also a new 5-year holding period. If you're in the 15% bracket and you've held the asset for more than 5 years, the long-term capital gain rate will be 8%.
Example--You purchased 100 shares of Madison Inc. in 1992 for $10,000. In January 2001 you sell the shares for $30,000. For 2001 you're in the 15% bracket for regular taxes. The $20,000 long-term capital gain will be taxed at 8% (instead of the usual 10%).
This is hardly a giveaway. However, if you're nearing the 5-year threshold, and you're in the 15% bracket, it may make sense to try and hold on just a while longer. Remember, investment objectives should be paramount.
This tax break may be more valuable to your children. It may make sense to give your son or daughter appreciated stock and have them sell it. Remember, if they're under 14 they pay tax at your rate.
Another rule applies to assets acquired after December 31, 2000. If held for 5 years gain on these assets will be taxed at only 18%, not 20%, no matter what tax bracket you're in. However, you must have acquired the assets after December 31, 2000.
Stock surrenders and redemptions. A surrender of stock by a dominant shareholder who retains control of the corporation is treated as a contribution to capital rather than as an immediate loss deductible from taxable income. The surrendering shareholder must reallocate his or her basis in the surrendered shares to the shares he or she retains.
A redemption of stock is generally treated as a sale and subject to the capital gain or loss rules unless the redemption is equivalent to a dividend or other distribution. Whether or not the redemption is equivalent to a dividend depends on the facts and circumstances. It depends importantly on your interest in the corporation before and after the redemption. If your proportionate ownership hasn't really changed, the redemption is treated as a dividend and the full amount received may be taxable at ordinary income rates.
Example 1--You own 50% of Madison Inc. Fred Flood (unrelated to you) owns the other 50%. Madison redeems 20 shares of your and Fred's stock. You both still own 50% so the amount received on the redemption is a dividend.
Example 2--The facts are the same as above, but Madison redeems only your shares. After the redemption, you own 20% of the company, Fred owns 80%. The capital gain rules apply.
Example 3--The facts are the same as in example 2, but Fred is your son. Since his shares are attributed to you and vice versa, you're considered to still have the same proportionate ownership. Any payments you received are considered dividends.
There are some special rules here. Just be aware that redemptions in a closely held corporation can present some expensive tax traps.
Next issue. We'll discuss carryforward losses, equipment and sales of other business assets, bonds, and special tax benefits available to small business owners.
Accounting Basics -- Capital Stock -- Part I
This is probably one of the least difficult areas of accounting, at least for most corporations. And, to make it easier, you probably won't have to make any entries during the course of the year. Moreover, if you use accounting software, it should handle the year-end closing entry automatically.
Having said that, you should know that many business owners make critical mistakes in this area. Most of them occur because nobody took the time to ensure that entries were properly made or the formalities of issuing stock, etc. were ignored. And that can cause real problems later. If you're audited, there's a good chance the IRS will review your minute books, check for the issuance of stock certificates, etc. Serious mistakes here could prove costly. In addition, if you don't treat your corporation as a separate entity and observe all the formalities, you may find that corporate protection lacking if you're sued.
In this article we'll discuss not only the accounting rules, but some of the important legal issues. With only a few exceptions, the same rules apply to both regular (C) and S corporations.
The Corporate Concept
Why incorporate? There are two basic reasons. The first is to protect the owners from unlimited legal liability for the actions of the business. The second is because you need some sort of separate entity if you're going to have multiple owners.
In a corporation the corporation owns the assets, earns the income and incurs the expenses, and is solely responsible for the debts of the corporation. It exists as an entity separate from the stockholders and generally has unlimited life. Ownership in the corporation is represented by shares of stock. The stock can generally be freely traded. (However, in closely held corporations there may be restrictions put on the transfer of ownership.)
As opposed to a partnership or sole proprietorship, a stockholder in a corporation can't be sued personally. The amount of his investment at risk is limited to the amount he paid to buy the stock. For example, assume Fred puts up $5,000 of equity capital in Madison Inc. A year later Madison goes bankrupt owing lenders and suppliers $100,000. Fred's out $5,000, but the company's creditors are out $100,000.
Why not set up the corporation with $1 of equity and borrow the rest of the money? Because lenders and suppliers are unlikely to put up the additional funds. They'll look at the balance sheet and quickly discover that they're the only ones at risk. Moreover, while the owners stand to reap all the potential profits, both in the form of dividends and capital gain from any sale of the stock, they're taking no risk. A corporation that has very little equity in relation to the amount of debt is called "thinly capitalized." A lender might loan money to a thinly capitalized corporation, but only if there is sufficient collateral or the shareholders guarantee the loans.
If the persons loaning money to the corporation are also shareholders, the IRS will look closely at a thinly capitalized corporation. Once again this is a win-win situation for the shareholders. If the corporation does well, they reap the benefits on their stock. If the corporation fails, they will try to deduct the loans as a bad debt. The IRS will argue that some or all of the loans should really be equity capital. Much of the time they are successful. A complete discussion of that issue is beyond this article. Discuss the issue with your tax advisor.
Authorized, issued, par value, etc.
Every corporation must issue at least one share of common stock. If you only have one stockholder you don't have to issue any more shares. And many closely held corporations do just that. It may sound foolish, but there can be business and tax consequences if you don't go through the formalities of issuing that share. If you've never done it, your accountant or attorney can help. You or your attorney should have ordered a "corporate kit" containing sample minutes and stock certificates. You simply issue a certificate in exchange for the cash or other assets contributed. Don't delay. Do it at the time the assets are received by the corporation.
Tip--You can contribute assets other than cash in exchange for the shares. In fact, it's not unusual for the shareholders in a newly formed corporation to contribute assets such as equipment, inventory, etc. and even services, however, special tax rules apply and there's a costly trap. Check with your tax advisor.
Authorized and issued. What's the difference? The corporate charter that you file with the state on incorporation will indicate the number of shares you're authorized to issue. For example, your certificate of incorporation may say that you're authorized to issue 20,000 shares of no par stock. If that's the case, issue 1 share more and you're in violation of the law. You can, of course, issue less. You can increase the number at any time if the shareholders agree to an increase and you file an amendment with the state.
The number of shares issued is the number of shares actually in the hands of shareholders. Thus, if you have 5 shareholders and issued each of them 100 shares, you'll have 500 shares issued and outstanding.
How many shares should have authorized when drafting the incorporation papers? For closely held corporations some professionals simply put down 200 shares. That could be a mistake. You may think that only you and your spouse will be shareholders, so 1 share each is all you need. However, what if you want to give some shares to your children, or a valued employee? Giving 1 share to the employee means he'll have 33.33% of the business. On the other hand, if you had even 1,000 shares authorized, you and your spouse could have 100 shares each. Giving 2 shares to the employee would mean he would have about 1% of the business.
On the other hand, since the cost of incorporating may depend on the number of shares authorized, you don't want to go overboard. A good starting suggestion is 20,000 shares.
Par value. The concept doesn't make as much sense as it did 75 years ago, but there's still an important legal issue. In the case of common stock par value is usually a nominal amount, often $0.01, $0.50, or $1.00. Stock can also have no par value. That doesn't mean that you can only contribute an amount equal to the par value for the shares. In fact, that's rare. Any amount contributed in excess of the par value is assigned to another account, often called "paid-in capital in excess of par" and sometimes called "additional paid-in capital."
Example--Fred Flood starts Madison Inc. by contributing $10,000 to the corporation. He receives 100 shares of stock with a $0.01 par value. Of the total, $1 ($0.01 times 100 shares) goes to the common stock account. The excess, $9,999, gets credited to paid-in capital in excess of par.
Here's what the accounting entry would look like:
Cash $10,000
Common stock $1
Paid-in capital in excess of par $9,999
This type of transaction is done all the time. But we mentioned that there's a legal issue. A problem can arise if you issue stock for less than the par value. For example, assume that Madison's common stock is $10 par value and the company issues 1,000 shares to Fred for $9,000 ($9 each). Issuing stock at a discount is illegal in many states. Even if it's not, Fred would have a contingent liability for $1,000.
Tip--There's no reason to get into this problem. When setting up the corporation, set the par value at a small amount, say $0.01 each. While no par stock sounds like an even better deal, there may be special rules in your state. If you really want to have no par stock, check with your attorney first.
Retained Earnings
The name of the account just about says it all. Retained earnings consists of the profits left in the business. It's one of the owner's equity accounts on your balance sheet. It could be the most important of all accounts--either on the income statement or balance sheet--because it shows the cumulative effect of the operations of the company. At the start of the business your retained earnings account is zero. It's increased by profits and decreased by losses and dividends or distributions to shareholders.
Example--Madison Inc. begins business on January 1, 2000. During the year it has a loss of $20,000. After the books are closed for the year the balance sheet will show a deficit in retained earnings of $20,000. Assume further that during 2001 the company has net profits of $160,000, but also declares a dividend to shareholders of $50,000. After the books are closed for 2001, the retained earnings account will be:
Balance at January 1, 2001 ($20,000)
Add: Net profit for 2001 160,000
Less: Dividends paid (50,000)
Balance at January 1, 2002 90,000
At the end of the year you'll close out your books. Part of the process is transferring the net profit or loss from the income statement (to reset income and expense the accounts to zero) to retained earnings. If you're using a computer program to handle your accounting, the process should be automatic when the program asks if you want to close your books. Caution. Make sure you enter any dividends or distributions in the proper account. Otherwise they may not be posted correctly at the end of the year.
Total stockholder's equity is equal to the amount of your capital stock, additional paid in capital, and retained earnings. When a lender or other creditor (such as a supplier) looks at your balance sheet, the first area they'll focus on is the equity accounts. While they certainly don't tell the whole story, they do give a quick overview of the company's ability to repay its debt.
Dividends
A true dividend is a distribution to shareholders out of retained earnings. If the amount of the distribution exceeds the balance in the retained earnings account, the excess is considered a return of capital. The payment of dividends is at the discretion of the board of directors and, for legal reasons, there should be a formal vote by the board on any payment of dividends. Make sure that's memorialized in the corporate minutes.
While the rules vary from state to state, the shareholders and/or the board of directors can be held liable should the corporation pay out dividends that reduce retained earnings below zero. That is, once dividends are paid out of the capital stock and accumulated paid-in capital account, you could have a problem. Check with your accountant and/or attorney. You should also be aware that the payment of a dividend to reduce the retained earnings account in order to avoid paying creditors may be a "fraudulent conveyance". Should that happen the directors and/or shareholders could be held liable.
Note, there can be important tax consequences associated with the payment of dividends. In a C corporation dividends are income to the shareholders, but aren't deductible by the corporation. The tax definition of a dividend is slightly different than the accounting definition. For tax purposes a dividend is a distribution out of "accumulated earnings and profits". That's similar to the accounting definition of retained earnings. This can be a complex area and beyond the scope of this article.
Dividends are declared per share of common stock. For example, the board of directors declares a $5.00 dividend on each share. If you own 1000 shares, your dividend would be $5,000. In that way each shareholder is treated equally.
Stock Dividends, Splits and Multiple Classes
Stock dividends and splits don't change the stockholder's total interest or rights in the corporation. They are just a means of increasing the number of shares outstanding into more units without changing the pro rata ownership by the shareholders. In closely held corporations that's often done so that a shareholder can gift shares to his or her children, to distribute shares to employees, or to lower the price to allow outsiders to buy in.
Example--Fred, Sue, Sharon, and Mike each own 10 shares of Madison Inc. Madison has been very successful and a recent appraisal put the per share value at $20,000 each (valuing the total company at $800,000, $20,000 per share X 40 shares). The shareholders would like to sell some shares to employees to raise capital and give them a stake in the business. However, the price is too high. Moreover, 10 employees are interested in purchasing shares. If they sold 10 shares the founding shareholders would reduce their ownership percentage below what they consider comfortable. The solution is to declare a 100-for- 1 stock dividend. Now each founding shareholder has 1,000 shares, each worth $200 per share. Neither their percentage ownership nor the total value of their holdings has changed. However, they can now either sell some of their shares to the employees or have the corporation sell the shares directly.
The results of a stock dividend are similar. However, there's a technical difference from an accounting standpoint. Since this is a rare transaction, we won't discuss it here. Check with your accountant. There are generally no tax consequences associated with either transaction, with one exception. If you have the option to take your dividend in cash or property instead of stock, the transaction will be taxable.
Why the big fuss when a publicly traded company splits it's stock? Theoretically, there should be no effect on the stock price. However, many investors perceive it as a good omen on the logic that the company is confident that the price of the stock will increase after the split. A lower per share price also makes it easier for investors to purchase shares and that should increase the price of the stock.
Multiple classes. In closely held corporations the founders often want to retain control of the business. That can be a problem if you also want to reward employees or increase incentives by giving them a stake in the company. You can usually create additional classes of common stock. For example, Class A may confer the full rights common shareholders are entitled to. Class B may only allow for limited (or no) voting or there may be a restriction on the transferability. You do have options to structure the equity portion of the balance sheet to achieve your objectives. Talk to your accountant and attorney. They should be able to help.
Caution--If you do business as an S corporation, you're limited to a single class of stock. There's one exception. You can have nonvoting stock.
Next issue. In our next issue we'll discuss treasury stock, options, warrants, percentage ownership effects, preferred stock and more.
You're probably familiar with Series EE (formerly E) savings bonds and might even know what Series HH (formerly H) bonds are. But you may not have heard of Series I savings bonds. They're relatively new (introduced in 1998) and, while they have much in common with Series EE bonds, there are a number of differences that make them more attractive.
Composite rate. The big difference is that the bonds earn interest through the application of a composite rate. The composite rate consists of a fixed rate that remains the same for the life of the bond and an inflation rate that changes twice a year. Interest earned from the composite rate accrues monthly and is compounded semiannually.
The inflation portion of the composite rate is based on the CPI (Consumer Price Index) and is reset every May and November. This gives the bond inflation protection. While inflation has been relatively tame for a number of years, the U.S. economy has seen double digit rates not that long ago. Fixed income securities (such as regular bonds) that are not indexed for inflation prove to be bad investments when inflation accelerates. Inflation protection should be an important consideration to individuals during their investment years and in retirement.
The second portion of the composite rate is a fixed rate of return that is set once and applies from the date of issue and continues unchanged until the bond reaches maturity, in 30 years. Thus, even though a new fixed rate is announced at the beginning of every May and November, the most recently announced fixed rate applies only to bonds purchased during the six months following its announcement.
Example--The Treasury announces a new fixed rate of 3% on May 1 and an inflation rate of 2.5% at that time. You purchase a bond on August 1. The composite rate is 5.5% (actually it's slightly higher because of the way the rate is computed). On November 1 the inflation portion is reset to 3.25%. From November 1 through the end of April of the following year the bond earns 6.25%. (The original fixed rate of 3% plus the new inflation rate of 3.25%.)
Thus, while the inflation rate is resent twice a year, the interest return is set for the life of the bond.
Interest computations. Interest is accrued at the beginning of each semiannual rate period. That is, the interest is compounded semiannually. However, interest on a bond accrues on the first day of each month. If you redeem a bond in the middle of the month, it will not earn any additional interest. For example, if you redeem a bond on June 30, you'll get no interest for the month of June. Wait one more day and redeem the bond on July 1 and you'll get a full months' interest.
Denominations, penalties. Unlike Series EE bonds, I bonds are issued at face value. They are sold in denominations of $50, $75, $100, $200, $500, $1,000, $5,000 and $10,000.
You cannot redeem a bond until six months after its issue date. If you redeem a bond before it turns five years old, there is a 3-month interest penalty.
Like Series EE bonds, there is a limit on how much you can invest every year. For Series I bonds the maximum is currently $30,000. Series I bonds reach final maturity in 30 years.
You can't exchange Series EE bonds for Series I bonds and you can't exchange I bonds for HH bonds.
The Bureau of the Public Debt is authorized to replace lost, stolen, or destroyed I bonds. You can file a claim by writing to: Bureau of the Public Debt, Parkersburg, West Virginia, 26106- 1328. Keep a list of the serial numbers of any bonds in a safe place.
Tax consequences. The tax consequences are similar to that for Series EE bonds. While I bonds are sold at face value and a portion of the return is based upon inflation, any increase over the purchase price is considered interest income. The interest is fully taxable for federal income tax purposes, but is exempt from state and local taxes.
Subject to certain income limitations, you may, for federal income tax purposes, be able to exclude all or a portion of the interest received upon redemption of a bond if you use the interest to pay for qualified educational expenses. The exemption only applies if the purchaser has reached age 24 before the date of issuance. Thus, if you want to get the benefit of this tax break, the parent and not the child has to purchase the bond.
Investment merit. Do Series I bonds make sense? At the current rate of 7.49%, the return is attractive. In fact, it's excellent when you consider the fact that from a credit standpoint it's a riskless investment. In addition, the inflation protection makes them more attractive than a similar government or private bond. In fact, one of the disadvantages of regular bonds is that they will decline in value when interest rates rise and interest rates are dependent on the inflation rate. The disadvantage is that you give up any chance of the bond increasing in value if interest rates should fall.
And, like Series EE bonds, the interest income is normally deferred until you redeem the bond. That means you can use it for tax planning. You can wait until retirement to redeem the bond, when you're in a lower bracket, or redeem it in a year when your taxable income is low.
Previously Reported In Daily Update
Best customers? . . . Who are they? The ones who will remain loyal to you. How can you identify them? Look for the ones that buy a range of items from you, not just the ones on sale or where you've got the lowest price. Customers that simply call and order all their needs from you not only provide a steady stream of revenue but also provide a higher return by buying products that carry a higher margin. Moreover, their higher average order and monthly balance makes servicing them cheaper. Try to reward those customers; they're the ones you want to keep.
Net lease has adverse tax consequences . . . Owning business real estate in your own name and renting it to your business generally makes sense. You can sell the real estate to generate cash, sell it separately should you sell the business, or keep it and rent it to the new owner of the business. But renting it under a net lease, that is, where the lessee (i.e., your business) is responsible for repairs, real estate taxes, utilities, etc. can be a mistake. If that's the case any losses won't qualify under the $25,000 exception for actively managed real estate. That could cost you a valuable deduction. There may be other consequences. Talk to your tax advisor.
Easier to order means easier to spend more . . . There's no question that there are considerable fixed costs associated with processing a purchase order. The estimates vary widely, but using traditional paper methods the whole process from cutting the purchase order to writing the check can easily cost between $25 and $125 dollars. Ordering the same product over the web can cut that cost considerably. How much? That's difficult to say. It depends on how much of the traditional processes you eliminate. But there's another side to the analysis. Doing business electronically can also reduce internal controls with two of the consequences being over ordering and ordering the wrong products. The best answer is to make sure purchases are still approved by a department head or other responsible person. Someone should also monitor prices. While they may be cheaper on the web, that's not always true when you add in shipping. And prices can vary widely among web suppliers.
Date your supplies . . . Office (and shop) supplies often have a shelf life, even if none is indicated on the product. Inks can dry out, tape and glues can deteriorate, and paper can become brittle. That's particularly true if the items are stored in a hostile environment such as high humidity or very high or low temperatures. Date your supplies when you receive them and rotate your stock. That is, when replenishing the shelves bring the old supplies forward and put the new ones in back.
IRA trap for beneficiaries . . . If a spouse inherits an IRA, the spouse is treated just like the original owner. That is, he or she has the same powers as the original owner did with respect to the IRA. That's not true if the beneficiary is someone other than a spouse. For example, you inherit an IRA from your father. If that's the case, you must keep the account in the name of the original IRA owner. In the example, that would be your father. You can change the investments and even transfer the account to another institution. But you can only make a direct trustee- to-trustee transfer. You can't take a distribution and roll over the funds with the 60-day time limit as you can with your own IRA. If you do so, the entire amount will be taxable immediately. What if you have to share the account with several brothers and sisters? You can split the account so that each of you can have different investments and take distributions differently, but the same rules apply. There are other, special rules which apply to beneficiaries. Get good advice. The dollars involved can be substantial and the rules can be tricky.
Switching to an S corporation? . . . If you do business as a C (regular) corporation and are considering a switch to an S corporation, analyze the decision carefully. If you've got carryforward losses as a C corporation, you may want to reconsider the switch until those losses are utilized. Once you switch to an S corporation the losses will be suspended indefinitely. The only way to use them is to switch back to a C corporation and use them to offset the corporation's income. Another point, if you have other shareholders, talk to them before beginning your analysis. All shareholders have to sign the election form. If one shareholder dissents because of disadvantages on his personal return, you'll have a problem.
On-line calculators . . . Many websites now have on-line calculators that allow you to compute the future value of an investment, the annual payment on an annuity, lease values, etc. They all seem to do a good job, but such computations often have built-in assumptions that you may not be aware of. These assumptions can have a significant impact on the result. When using the calculators, enter your data carefully and then check the assumptions. If you can't find any info, put the same numbers into another on-line calculator or two and compare the results.
Income averaging for farmers . . . Farmer's may be able to income average their farm income, and that can provide considerable tax savings depending on the amount of the swing. However, it appears that the instructions for Schedule J may be at odds with tax law and what Congress intended. The issue concerns the use of a negative amount. Check with your tax advisor to see if you have a problem.
Depreciating computer software . . . If you purchase software bundled with a computer, the cost of the software must be depreciated along with the computer, over 5 years. On the other hand, if you purchase the software separately or the price is separately stated, you can amortize the software over 36 months.
Crackdown on family limited partnerships possible . . . There can be a number of reasons for setting up a family limited partnership. One is that, for valuation purposes, an interest in the partnership should be valued at less than the underlying assets. The theory is that the fair market value should be discounted because of the inability to easily dispose of the partnership interest. That discount could be anywhere between 25% and 40% or more. And that can provide considerable savings when it comes to estate and gift taxes. There's pressure to change the law, but the change may be selective. Changes may only affect partnerships where the assets are readily marketable securities or personal assets. Family limited partnerships that hold interests in active businesses (e.g., a family business, farm, etc.) may not be affected. While such partnerships can be advantageous, talk to your tax advisor. You'll be on safer ground if you can show a business purpose.
Self-employment earnings and S corporations . . . Any net earnings you report on Schedule C on your 1040 are considered self-employment earnings and subject to the self-employment tax. So are earnings from a partnership. And the two can offset one another. But even though an S corporation is similar in many respects to a partnership, the same rule doesn't apply. Any loss from the S corporation can't be used to offset self-employment income.
Copyright 2000 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536