News On The Tax Front--The latest tax news.
In Brief:--Tax, business, and personal finance tips.
Previously Reported In Daily Update
Just because you got a bill from someone doesn't mean the IRS can't challenge the deduction. In Interex, Inc. (T.C. Memo. 2002-57) the taxpayer deducted accounting fees of some $67,000. The company had paid compensation to it's sole shareholder of $42,000 and salary and wages of $6,700. Of the $67,000 in accounting fees, $65,000 was accrued on the return but not paid until several years later, after the audit had commenced. The sole shareholder did not realize that the professional fees were claimed as a deduction when she signed the return. The CPA had no documentation such as timesheets to support the claimed fee and the taxpayer had not received an invoice or other itemization for the services. The Court disallowed a deduction for the accrued about, holding that economic performance with respect to the amount.
Generally, the burden of proof is on the taxpayer to show he is entitled to a deduction, the income doesn't belong to him, etc. That's not true in the case of fraud. The IRS has the burden of proof and must prove its case by clear and convincing evidence. In Terrell Equipment Company, Inc. et al. (T.C. Memo. 2002-58) the IRS did not meet this burden. Thus, the taxpayer was held not to be liable for the fraud penalties or additional taxes.
The IRS and the courts can recharacterize a transaction if it doesn't represent economic reality. In Robert B. Rogers, Successor Executor for the Estate of Ewing M. Kauffman (2002-1 USTC 50,240; U.S. Court of Appeals, 10th Circuit) the taxpayer took a $34 million bad debt deduction for a loan his S corporation made to a former owner. The Court found that the "loan" was really a device to redeem the stock held by that owner. The loan was made and shortly thereafter the debtor defaulted and his shares (the collateral) were returned to the company. The company held the collateral had no value at that time. The Court denied the deduction, noting the taxpayer had no economic incentive to repay the debt.
If you are a business owner and get substantial gifts from relatives, keeping good records can be essential. In Joseph D. and Mi Jung Park, et al. (T.C. Memo. 2002-50) the IRS claimed that the taxpayers had unreported income from businesses for which they reported substantial losses over several years. The IRS used the bank deposits method to reconstruct their income. The taxpayers were able to convince the Court that the source of much of the deposits were the substantial gifts from family members they had received. The taxpayers won here, but the IRS usually triumphs. Keep good documentation of gifts and loans from family members.
Just because the money is not in your hands doesn't mean that it's not reportable for tax purposes. In Lee G. Gale (T.C. Memo. 2002-54) the Court found the taxpayer was in constructive receipt of the full proceeds from a settlement agreement in the year paid, despite the fact that the attorney had restricted his access to the monies.
If you sustain a casualty loss, you can only take a deduction for the loss if there is a reasonable prospect of recovery. That was the situation in Henry A. Julicher (T.C. Memo. 2002-55). The taxpayer claimed the deduction in the year the casualty occurred, despite the fact that he was covered by insurance. The Court held that at that time he had a reasonable prospect of recovery from the insurer. It wasn't until the following year when his claim was denied that he was allowed to take the loss.
The IRS has announced that American Express Co. has agreed to provide information to the IRS concerning taxpayer offshore accounts in Caribbean countries in the Cayman Islands, Antigua, and Barbados. The IRS will receive information that identifies taxpayers with offshore accounts, such as driver's license and passport numbers. MasterCard has provided information on over 230,000 accounts and Visa is expected to do likewise shortly. Other credit card companies are expected to also provide such information.
You can only deduct travel expenses to a job outside your general area if you're away from home. If you spend too much time at the distant location, the IRS will argue that your tax home is where you work, not where you live, and when at work you're not away from home. In Lon A. Bjornstad (T.C. Memo. 2002-47) a musician lived in Wisconsin about half of the week but went to Chicago for long weekends to play in a band. The IRS disallowed his hotel and meal expenses in and the travel expenses to and from Chicago. The IRS said that the only reason he lived in Wisconsin was personal. The Court noted that the band was based in Chicago. It didn't help that the band paid for his expenses when traveling to other cities, but not in Chicago. The Court sided with the IRS, denying meal, lodging and travel expenses in and to and from Chicago.
You can't avoid income by refusing to accept the check. In Diana T. Visco (2002-1 USTC 50,232; U.S. Court of Appeals, 3rd Circuit) the Court found that a reading specialist had to report as income back pay and interest that her former employer attempted to pay her, despite the fact that she sent back the checks in order to preserve her rights in a dispute with the employer.
In an earlier revenue procedure (Rev. Proc. 2000-46) the Service reported it would not issue advance rulings or determination letters on the questions of whether an undivided fractional interest in real property is an interest in an entity that is not eligible for tax-free exchange under Sec. 1031(a)(1) and whether arrangements where taxpayers acquire undivided fractional interests in real property constitute separate entities for tax purposes under Sec. 7701. Section 301.7701-1(a)(2) provides that a joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom, but the mere co-ownership of property that is maintained, kept in repair, and rented or leased does not constitute a separate entity for federal tax purposes. This new revenue procedure (Rev. Proc. 2002-22; IRB 2002-14) specifies the conditions under which the IRS will consider a request for a ruling that an undivided fractional interest in rental real property is not an interest in a business entity.
Section 911(a) of the Code allows a "qualified individual," to exclude foreign earned income and housing cost amounts from gross income. Section 911(c)(3) of the Code allows a qualified individual to deduct housing cost amounts from gross income. In Rev. Proc. 2002-20 (IRB 2002-14) the IRS has published the current list of countries for which the foreign earned income exclusion eligibility requirements of Sec. 911(d)(1) are waived for 2001.
President Bush has proposed additional tax cuts intended to assist small business owners purchase new equipment, to provide health insurance to employees and to eliminate the estate tax. One provision would increase the Sec. 179 expense option to $40,000 annually. Another would provide a credit for employers providing health insurance for their employees.
The IRS has posted to its web site revised depreciation forms (Form 4562) for use with your 2001 return and expects to add new instructions for claiming net operating losses soon. The materials reflect changes made by the recently-enacted Job Creation and Worker Assistance Act. If you acquired new depreciable property after Sept. 10, 2001, may be able to claim additional first year depreciation of 30 percent of the basis of the property. The law also raised the limitation on first-year depreciation for automobiles by $4,600 for new cars placed in service after Sept. 10, 2001. You may also choose not to use the increased deductions for qualifying property. If you qualify for the additional depreciation you should use the revised Form 4562, Depreciation and Amortization, or the revised Form 2106, Employee Business Expenses, as appropriate, with your tax returns. If you have already filed your 2001 return, you may file an amended return using Form 1040-X or 1120-X and the revised forms to get these tax benefits. The new law also provides a five-year carryback period for a net operating loss (NOL) arising in a tax year ending in 2001 or 2002. For purposes of the alternative minimum tax, any NOL carryback from those years, or carryforwards to those years, may offset the full alternative minimum taxable income, not just 90 percent of it. The IRS is revising the instructions for various forms that relate to NOLs and will post the revisions to its web site. It is also developing other materials related to the new law. A home page link to New Law May Cut Your 2001 Tax gives details. (Internal Revenue News Release IR-2002-37)
The IRS has announced that taxpayers can now charge their federal taxes on their VISA cards. This option means that you can now use any of the four major credit cards, VISA, MasterCard, American Express or Discover, for federal tax payments. Keep in mind that the processors charge a convenience fee for making payments. The IRS electronic payment program also includes an electronic funds withdrawal (EFW) option. Taxpayers who e-file their returns may authorize an EFW from a checking or savings account. You may schedule the payment for a future date, up to and including April 15. E-filers may schedule EFWs for the 2001 tax due and one 2002 estimated tax payment. If you request a filing extension by phone or computer you may also make an EFW payment. (Internal Revenue News Release IR-2002-36)
The IRS has just issued (REG-112991-01) corrections to the proposed regulations on the research credit. The corrections make changes to the examples and change the date in Sec. 1.41-3(e) from December 21 to December 26.
In Michael E. Nestor (118 TC--, No. 10) the taxpayer argued that the deficiency notices he received were not valid and that the IRS abused its discretion when it proceeded with collection when the appeals officer did not have documents demanded by the taxpayer. The Court found that the taxpayer could not contest the liability because he received notices of deficiency and those notices were properly completed and the documents presented by the appeals officer, Forms 4340, Certificate of Assessments and Payments, were sufficient to verify the assessments.
You may be able to shift the burden of proof to the IRS, but only if you cooperate with the Service and supply requested documentation. In Karen Boyd (T.C. Memo. 2002-46) the taxpayer failed to provide that documentation. The Court found the burden of proof was not switched. Moreover, because the taxpayer did not have a mileage log for her auto, the Tax Court denied her deductions for repairs and maintenance. Finally, the Court allowed the imposition of the negligence penalty. The taxpayer argued that she provided her accountant with the required documentation to prepare her return. The Court didn't buy that, particularly in light of the fact that she could not present the required documentation at trial.
In Richard J. Bot and Phyllis Bot (118 TC--, No. 8) the Court found the taxpayers liable for the self-employment tax despite the fact that they had retired from farming. The taxpayers desired to remain active members in the local farm cooperative. To do so they were required to sell corn to the cooperative. They did so by buying corn from a pool maintained by the cooperative.
The IRS has issued Publication 3920, explaining how to file claims under the Victims of Terrorism Tax Relief Act of 2001. Under this law, the federal income tax liability of those killed in terrorist attacks within the U.S. is erased for at least two years. See also Internal Revenue News Release IR-2002-23.
If you're worried about the IRS getting a return (particularly important if you owe an amount or you're filing a refund claim near the deadline, etc.) you should mail it registered, return receipt requested. In Rolly J. Sorrentino and Joann M. Sorrentino (2002-1 USTC 50,227; U.S. District Court, Dist. Colo.) the taxpayers didn't take the extra step with a refund claim. The filed the claim in early March, 1998 shortly before the April 15, 1998 deadline. The taxpayer didn't follow up until September, 1998 when he was told the IRS had no record of the claim. He then sent a copy of the signed return. The Court sided with the taxpayer in finding that, based on his copy and testimony, that the couple was entitled to a rebuttable presumption that, under the common law mailbox rule, that he mailed the claim on time and that it should have been delivered before the deadline. (Best advice? Send it registered, return receipt requested.)
If you're late in filing a return, the IRS can deny your claim for a refund. In Roxie Lee Jackson (T.C. Memo. 2002-44) the Tax Court sided with the IRS in denying the taxpayer a refund because he did not file a refund before the IRS issued deficiency notices and the taxes were deemed paid more than 2 years before the notice was mailed. A letter he sent with information related to his entitlement to the refund was not considered a refund claim.
In Harold Wapnick (T.C. Memo. 2002-45) the IRS reconstructed the income of an accountant. The taxpayer claimed that the income should be attributed to various corporations. The IRS found that the corporations never filed returns, had false ID numbers, and followed none of the usual corporate formalities.
If your spouse fails to report income, takes deductions to which he or she is not entitled, etc. you may not be liable for the additional tax and penalties. However, in order to claim innocent spouse treatment you have to show that you did not have knowledge of the understatement. In Kathryn Cheshire (2002-1 USTC 50,222; U.S. Court of Appeals, 5th Circuit) the taxpayer knew of the income understatement (pension distributions were omitted) when she signed the return.
If you're divorced, you don't have to have custody of a son or daughter in order to claim the dependency exemption. However, in John Jeter (2002-1 USTC 50,223; U.S. Court of Appeals, 4th Circuit) the taxpayer was awarded joint custody with his estranged wife, but the spouse had physical custody for most of the year. Furthermore, she did not release her claim to the exemptions (as she could have done) and there was no multiple support agreement in place.
A new revenue procedure (Rev. Proc. 2002-17; IRB 2002-13) provides automobile dealers with a safe harbor method of accounting for their vehicle parts inventory. This safe harbor method permits auto dealers to approximate the cost of their vehicle parts inventory using the replacement cost of the vehicle parts pursuant to the replacement cost method described in this revenue procedure. This revenue procedure also provides procedures for automobile dealers to obtain the automatic consent of the Commissioner to change to the replacement cost method.
In Andrew Heisey (T.C. Memo. 2002-41) the taxpayer argued that the federal income tax was really an excise tax and that he was not liable for a tax on his wages and other compensation. The Court found otherwise and, because his arguments were considered frivolous, also found him liable for the delay penalty. The Court determined the penalty to be $2,000 (it can be as much as $25,000). The IRS has issued a new revenue procedure (Rev. Proc. 2002-18; IRB 2002-13) which provides guidance on involuntary change of accounting methods under IRC Sec. 446(b) and Reg. Sec. 1.446-1(b). This Rev. Proc. modifies Notice 98-31 (IRB 1998-1).
The IRS has issued a new revenue procedure (Rev. Proc. 2002-19; IRB 2002-13) which modifies Rev. Proc. 97-27. These revenue procedures provide procedures under which taxpayers may obtain the advance consent of the IRS to change a method of accounting. In addition, this new revenue procedure modifies Rev. Proc. 2002-9, 2002-3 I.R.B. 327, which provides procedures for taxpayers within the scope of that revenue procedure to obtain automatic consent to change a method of accounting. The changes to Rev. Proc. 97-27 and Rev. Proc. 2002-9 include:
For a discussion of the policy reasons for certain of the modifications provided by this revenue procedure, see Announcement 2002-37, IRB 2002-13.
In Internal Revenue News Release IR-2002-32 the IRS reported that it has issued a new publication to help taxpayers and charities understand the rules for documenting charitable deductions claimed on federal tax returns. Publication 1771, Charitable Contributions-Substantiation and Disclosure Requirements, also explains new guidelines that allow charities to electronically mail documentation to donors.
Legal fees are flags on almost any tax return. Why? Because they're frequently either totally nondeductible or they might have to be capitalized and deducted over a period of time. In Capital Video Corporation (T.C. Memo. 2002-40) the Court disallowed a deduction to the corporation for legal expenses incurred to defend the sole shareholder from criminal charges. Some of the fees were incurred as a result of criminal actions the shareholder took to assist a crime family. The corporation reasoned the amounts were part of the protection money it had to pay the crime family. The Court didn't agree. The Court also sided with the IRS in holding that the payment of the legal fees were a constructive dividend to the shareholder. However, the Court refused to assess the negligence penalty because the tax preparer had relied on case law available to him at the time.
If property is damaged or destroyed in a casualty and you receive funds either by selling the damaged property or through insurance, you must recognize gain unless you replace the property within the required time period. For example, your business car is destroyed in an accident. You receive $5,000 in insurance proceeds. Unless you buy another vehicle within the time limit, you'll have to treat the $5,000 as if you sold the vehicle. In Willamette Industries, Inc, (118 TC--, No. 7) the taxpayer, a forest products company, sustained damage to its trees in a hurricane. The taxpayer harvested the damaged trees and processed them in its own facilities. The IRS argued that, in order to claim a deferral of gain, it could do so only by selling them. The Court sided with the taxpayer. It cited the Service's own ruling (Rev. Rul. 80-175). It noted that the taxpayer shouldn't be denied deferral treatment simply because it salvaged the trees itself.
Auto expenses are another area that the IRS scrutinizes carefully on audit. In Michael R. Olsen and Sheila Olsen (T.C. Memo. 2002-42) the Tax Court found that the taxpayers' mileage summary were not based on actual odometer readings at the time the trips were made, but were reconstructed through other methods. In addition, they could not document the costs they deducted for truck repairs and maintenance.
The courts are getting impatient with taxpayers who employ delaying tactics. In fact, there are a number of sanctions they can impose. In Patricia R. Carpentier (T.C. Memo. 2002-43) the Court dismissed the taxpayer's case after several venue changes and a number of delays. The Court also assessed a delay penalty of $15,000.
Previously Reported In Daily Update
Requesting an extension . . . It's getting close. If you can't make the deadline, you can get an automatic 4-month extension of time to file your federal income tax return. State rules vary, but many states accept the federal extension. (Remember, this is an extension of time to file the return, not pay the tax. There's a penalty for paying late. You must be generally paid up by the due date of the return. Similar rules generally apply for state purposes.) You can download From 4868 from the web, but you don't have to mail it to the IRS. You can request an extension by telephone by calling 1-888-796-1074. You can even pay any amount due by charging it to your American Express, Discover Card or MasterCard or by electronic funds withdrawal from a checking or savings account. Simply provide the appropriate bank routing and account numbers for the account. You'll also have to provide your AGI from your 2000 tax return to verify your identity.
Worried about getting paid? . . . Many businesses have cash flow problems. And, while an upturn in the economy is forecast, those problems could continue for some time. If you're worried about getting paid on a long-term transaction, such as rental payments on a lease or on the sale of your business, you can ask the debtor for a letter of credit. These are guarantees issued by banks and insurance companies. If the debtor can't pay, the bank has to do so. In effect, the creditworthiness of the bank is being substituted for that of the debtor. Of course, if the debtor is on shaky ground, the letter of credit won't come cheap. Talk to your banker and financial adviser.
Taxability of interest income . . . Using a program to do your taxes is almost essential these days. Put the numbers in correctly and the program will take into account all the nuances of the tax law. However, inputting some amounts can be tricky. Interest (and dividend) income is one of those tricky items. Here are two points to keep in mind:
Top errors by paid preparers . . . For a number of years the IRS has posted the top errors made by individuals and paid preparers during the tax season. Guess what the top one was this year (through March 15.) for paid preparers. If you said the rate reduction credit, you were right. Actually, it was the first, second, and fourth most common error. The first was that a taxpayer was entitled to the credit, but it wasn't computed. The second was that the credit was claimed, but shouldn't have been. The fourth was that the rate reduction credit was figured or entered incorrectly. The other errors, in order, were:
Penalty for underpayment of estimated tax . . . Just because you're getting a refund doesn't mean you're not liable for the penalty for underpaying your estimated tax. You shouldn't be liable for the penalty if your withholdings and estimated tax payments for 2001 equal or exceed your liability for 2000 and you made your required estimated tax payments on time and in equal amounts. For example, you should have made your first estimated payment of $2,000 on April 15, 2001. However, you didn't have the cash so you doubled up on the second payment, paying $4,000. Since the second payment was due June 15, you would have been underpaid for 2 months. You owe the penalty on $2,000 for 2 months. If you're not using a computer program to do your return, you can compute the amount of the penalty by completing Form 2210 (for individuals). Most states have similar rules. By the way, the calculations can be extremely tedious. This is one time when software is more than worth it.
Underfunded pension plan excise tax can be 100% . . . Setting up a pension plan can result in both tax benefits and improved employee morale. But a plan shouldn't be taken lightly. You've got to make sure you conform to all the rules. Failure to follow some rules can result in the plan being disqualified. Failure to fund the plan can have serious tax consequences. The law imposes a 10% tax (called the first-tier excise tax) for any year in which an underfunded condition occurs. For example, if the plan is underfunded by $5,000 in 2002 the tax is $500. If the funding continues into 2003, there is another $500 tax due. It can be much worse. If the underfunded condition is not corrected before the IRS mails you a deficiency notice, the tax increases to 100% (the second-tier excise tax) for each year the underfunded condition continues. You may have options. But this is a complex area. You need advice from a pension professional.
States may restrict business breaks . . . In the past we've discussed the tax and nontax incentives many states give to businesses expanding in or relocating to their state. The breaks can include special tax abatements, low interest rate financing, etc. We've also recently mentioned that many states are having difficulty balancing their budgets. Recent federal tax law changes aren't helping (many states link their tax laws to the Internal Revenue Code). It now appears that more than one state is cutting the funds available for these business incentives. From the state's standpoint, it makes sense too. It's easier to cut back on a break that isn't mandated by law that to change the state's tax rate. (It's also politically more palatable.) If you were thinking about getting a piece of this pie, now is the time to reach for it. Many states may be taking these incentives off the table.
Check the boxes . . . Whether you're preparing your personal return or your business (corporation, partnership, etc.) return, there are a number of boxes that may have to be checked -- or left blank. Don't ignore them. Doing so could be costly. In some cases checking a box may allow you to make an election that could save you taxes. In some you're making a statement. For example, if you use a vehicle in your business or use a personal vehicle for business you'll have to check some boxes to make statements about the usage and whether or not records were kept. Sometimes checking a box that you shouldn't have can subject you to negligence or even perjury penalties. For example, on Schedule B you check the NO box in response to the " . . . did you have an interest in or signature or other authority over a financial account in a foreign country . . . " when in fact, you did have an interest in such an account.
Medical deductions . . . In order to deduct any medical expenses, your total has to exceed 7.5% of your adjusted gross income (AGI). Here are some expenses you might overlook in reaching that total:
However, you can't deduct insurance premiums you paid with pretax dollars. For example, if you have money taken out of your pay for a flex-pay or cafeteria plan and use the funds to buy health insurance coverage.
Extensions by phone . . . Anyone who filed a tax return last year can use the phone to request an automatic extension of time -- to August 15, 2002 -- to file his or her tax return. This system will operate from March 1 to April 15, at 1-888-796-1074. Form 4868, Application for Automatic Extension of Time To File U.S. Individual Income Tax Return, has details on required information and explains how to pay a balance by phone.
State and local tax deduction . . . Your deduction for state and local taxes on your federal return can be as simple as the amount on your W-2. Or, it could be much more involved. Here's what you should put on Schedule A of your federal return:
For estimated taxes paid in 2001 include checks written in 2001 for 2001 and your last estimated payment for 2000 if paid in 2001 (i.e., paid in January 2001). If you made your last estimated payment for 2001 in January of 2002, that payment will be deductible on your 2002 return. Any overpayment on your 2000 return will be income for 2001 (unless you didn't itemize or got no benefit for state taxes paid on your 2000 return). Remember, you can't net the refund if you applied it toward your estimated taxes.
Copyright 2002 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