Small Business Taxes & Management

News On The Tax Front--The latest tax news.

Paid a Deposit Penalty on Form 941? You May be Able to Get a Refund

In Brief:--Tax, business, and personal finance tips.

News On The Tax Front

Previously Reported In Daily Update

In Internal Revenue News Release IR-2004-72 the IRS is reminding taxpayers that e-file, its electronic filing service, remains available for their use long after the regular April 15 filing deadline. The IRS expects some 10 million taxpayers to file after April 15. IRS e-file will be available through Oct. 15 to serve these taxpayers. In addition, several private companies participating in the Free File program will also continue to provide free return preparation and e-filing services to eligible taxpayers through mid-October. For taxpayers who didn't get an extension, e-filing offers another advantage. Returns get to the IRS quicker, reducing the amount of interest and penalties they'll owe.

In Rev. Rul. 2004-59 (IRB 2004-24) the IRS held that if an unincorporated state law entity that is classified as a partnership for federal tax purposes (i.e., an LLC) converts into a state law corporation under a state law formless conversion statute, the following is deemed to occur--the partnership contributes all its assets and liabilities to the corporation in exchange for stock in such corporation, and immediately thereafter, the partnership liquidates distributing the stock of the corporation to its partners.

The holiday rule allows you to file on the first business day after the holiday and still file on time. For example, if April 15 falls on a Sunday, your return is due on Monday. The same rule applies to extended due dates. That is, if you have an extension to August 15 and that day is a Saturday, your return is due on Monday, the 17th. You have three years from the due date of your return to file a return and claim a refund. In Emanuel Weisbart (2004-1 USTC 50,230; U.S. District Court, East. Dist. N.Y.) that, since the initial due date of August 15, 1993 fell on a Sunday, the return was originally due on August 16, 1993. The taxpayer reasoned that three years from that date would be August 16, 1996 and that would be the last day to file a refund claim. But the Court agreed with the IRS that the taxpayer had only three years from the original due date, before any extension for the holiday. That meant his claim was late by one day.

It's almost impossible to challenge the IRS regulations. While it's somewhat easier to argue revenue procedures are wrong, it's very tough to win in court. In Charles A. Boyd and Darby A. Harvey, f.k.a. Darby A. Boyd, et al. (122 TC--, No. 18) the taxpayers operated a trucking company and paid drivers a per diem amount computed on a per-mile basis. The taxpayers argued that the per diem allowance covered both meals and incidental expenses (M&IE) and lodging. Split according to the rules, 40% should represent M&IE, 60% should represent lodging. The M&IE portion would be subject to the 50% disallowance rule for meal expenses; the 60% representing lodging would be fully deductible by the taxpayer. The Court sided with the IRS and disagreed. Because the per diem was computed using the same method as the employee's wages (miles traveled in this case), the per diem allowance was deemed to be paid as a "meals only per diem allowance" under the test set forth in section 4.02(5) of the revenue procedures. When a per diem allowance is deemed paid as a "meals only per diem allowance", the revenue procedures provide for a 50-percent deduction of the entire per diem allowance and do not allow for a greater deduction when a taxpayer provides estimates regarding the average nonmeal expenses. Indeed, the purpose of the deemed substantiation under the revenue procedures is to avoid the need for additional evidence and subjective interpretations and to provide taxpayers with clear and objective tests, even if such tests fail to mirror actual expenditures. Thus, the Court held the entire allowance was subject to the 50% rule.

The IRS can issue a summons to obtain records from third-party recordkeepers, such as your bank, but you have an opportunity to go to court to quash the summons. In Thomas E. Tilley, et al. (2004-1 USTC 50,221; U.S. District Court, West. Dist. Va., Danville Div.) the taxpayers did just that. But such motions must be filed within 20 days from the date notice is given and notice is considered to be given on the date it is mailed. While the taxpayers mailed their petition on the day before the deadline, the petition was not filed with the Court until four days after the statutory period expired.

Some taxpayers have invested in tax shelters with the belief that their names would not be revealed to the IRS. In John Doe v. KPMG, L.L.P. (2004-1 USTC 50,223; U.S. District Court, No. Dist. Texas, Dallas Div.) the Court held that the IRS could require the IRS could require a national accounting firm to disclose the names of participants in a tax shelter for whom the firm prepared returns and provided tax advice. The Court held that disclosing their names would not reveal any confidential communications associated with the transactions.

The House has passed (271-139) a bill (H.R. 4359) that would make the $1,000 child tax credit permanent and raise the income threshold from $110,000 to $250,000 for married couples and from $75,000 to $125,000 for individuals.

You can deduct your share of losses incurred by an S corporation, partnership, LLC, or sole proprietorship up to your basis in the entity. Your basis in the entity includes both your equity and debt basis. In the case of a partnership and LLC, your basis can include not only amounts you provided directly to the entity, but also amounts for which you are personally liable. In IPO II, A Partnership, Gerald R. Forsythe, Tax Matters Partner (122 TC--, No. 17) the LLC incurred losses from the leasing of an aircraft. Mr. Forsythe had a 1% interest in the LLC; an S corporation he controlled owned the other 99%. The taxpayer argued that the debt should be allocated to Mr. Forsythe and to the S corporation. If that were the case, the S corporation would be entitled to the its share of the losses and Mr. Forsythe, as the shareholder in the S corporation would be able to deduct the losses. But the Tax Court held that the debt could not be allocated between Mr. Forsythe and the S corporation because the S corporation would not bear the risk of loss.

It's occasionally possible to best the IRS by winning on a procedural issue or technicality. But it's rare. In William H. Johnston and Nancy S. Johnston (T.C. Memo. 2004-107) the taxpayers contended that they were not liable for tax for the years at issue because the notices of deficiency were invalid. They contended that: (1) the IRS may not determine a deficiency for a year for which a taxpayer did not file a return; (2) taxpayers' income is not taxable because they did not file returns; and (3) the IRS did not prepare a return for each of the years in issue that qualified as a substitute return under section 6020(b). The Court did not agree. It said the taxpayers' contention that the IRS cannot determine a deficiency for a year for which a taxpayer did not file a return is frivolous. The taxpayers' contention that failure to file a return shields the nonfiler from income tax liability is also frivolous. Where a taxpayer files no return, the deficiency is determined as if a return had been filed on which the taxpayer reported that the amount of tax due was zero; thus, the deficiency is the amount of tax due. Finally, the Court said the taxpayers' contention that the Commissioner must file a substitute for return under section 6020(b) before determining a deficiency is also frivolous. The Court also added penalties for delaying and advancing frivolous arguments.

You may be able to settle your tax liability for less than the full amount if the IRS agrees to an offer in compromise. In Russell L. Voorhees (T.C. Memo. 2004-105) the taxpayer argued that the Appeals officer abused his discretion in rejecting the taxpayers offer in compromise. The Court, however, sided with the IRS. The Court noted the Appeals officer reviewed the taxpayer's financial information before rejecting the offer. The Appeals officer believed the taxpayer could satisfy his outstanding liabilities. The Court agreed.

The IRS has issued final and proposed regulations (T.D. 9129; REG-148399-02) relating to the capitalization of interest expense incurred in sale and leaseback transactions under the Economic Recovery Tax Act of 1981 safe harbor leasing provisions. The regulations affect taxpayers that provide purchase money obligations in connection with these transactions.

In Padgett Coventry Price (T.C. Memo. 2004-103) the IRS used a combination of the specific items method of proof and the bank deposits method of proof to reconstruct taxpayer's gross receipts from her law firm. The Court noted that the specific items method is a direct method of proof, and it has been approved by the Court. The bank deposits method of proof is well established. The Court upheld the Service's reconstruction of the taxpayer's income. The Court also sided with the IRS in disallowing unsubstantiated deductions on the taxpayer's Schedule C and Schedule E. Finally, the Court held the taxpayer did not introduce sufficient evidence at trial to establish that there was an embezzlement from the law firm, what the amount of the alleged embezzlement was, or precisely when the embezzlement occurred or was discovered. The Court said the taxpayer failed to establish that she is entitled to a theft loss for any of the years in issue.

Not all debts are discharged in bankruptcy. In Gregory Iannone (122 TC--, No. 16) the IRS agreed that the taxpayer's personal tax liability was discharged in the bankruptcy, federal tax liens are not extinguished by personal discharge in bankruptcy. A discharge of personal liability in bankruptcy "extinguishes only one mode of enforcing a claim--namely, an action against the debtor in personam--while leaving intact another--namely, an action against the debtor in rem." Johnson v. Home State Bank. Any existing federal tax liens remain in effect and attach to assets owned prior to the date of filing the bankruptcy petition. A preexisting lien on property, however, remains enforceable against that property even after an individual's personal liability has been discharged. The Court held that the IRS could put a lien on the taxpayer's 401(k) account.

The Justice Department's Tax Division announced that the U.S. District Court for the Northern District of Illinois ordered the law firm Jenkens & Gilchrist, P.C., to comply with IRS summonses seeking identities and other information relevant to the IRS investigation into certain tax shelters promoted by the firm. "Tax shelter customers and promoters have thrown up one obstacle after another in their effort to keep the IRS from learning their identities and the details of their transactions. As one court after another takes a close look at the tax shelter industry, those obstacles are falling like dominoes," said Eileen J. O'Connor, Assistant Attorney General for the Department of Justice Tax Division. "The Court's order affirms the government's position that customers of tax-shelter promoters cannot shield their identities from the government, even if the promoter is a law firm." The District Court's order rejects Jenkens & Gilchrist's arguments for concealing the identities of the investors who purchased the tax shelters it marketed, and it required disclosure to the government of all their identities. The order permits the customers to seek to intervene in the matter to assert attorney-client privilege as to particular documents, but otherwise requires Jenkens & Gilchrist to turn over client files, too. The Court's order warns clients who may want to assert a privilege to prevent disclosure of particular documents that the Court found little basis for existence of a privilege among the documents it has already examined, and that it would consider imposing sanctions for frivolous claims of privilege.

In Internal Revenue News Release IR-2004-68 the IRS announced that numerous free resources for small business taxpayers are available at the IRS web site at www.irs.gov/smallbiz. The IRS has checklists for those starting a new business, business expenses and taxes for those operating a business, information on closing down a business, information on specific industries, free guides for small business owners, IRS courses, links to state government and commercial web sites, and links to IRS services such as E-file, applying for an employer identification number, and Electronic Federal Tax Payment System (EFTPS).

The IRS has announced (IR-2004-69) the introduction of two new tools to help small businesses keep their employee retirement plans compliant with federal tax law. These tools -- a suite of retirement-plan "Check-Ups" and an employer newsletter -- will help employers better understand their retirement plans and stay up to date with new developments. To ensure the compliance of their retirement plans, the IRS encourages business owners to review one of three Check-Ups -- for SIMPLE IRA, SEP or SARSEP retirement plans -- which are found on the Retirement Plans page on IRS.gov. Each Check-Up is geared to one of these IRA-based retirement plans commonly operated by small businesses. For more information, got to www.irs.gov/retirement/index.html.

The House Rules Committee has passed H.R. 4359, a bill that would extend expiring tax cuts and extend permanently the $1,000 child credit. The bill would also raise the income limits on the child credit to $125,000 for individuals and $250,000 for joint returns (up from $75,000 and $110,000).

If you're in business and make a payment to a service provider, you generally have to file a 1099 for the amount of the payment. In Rev. Rul. 2004-46 (IRB 2004-20) the IRS described the correct reporting in a situation where a publisher pays royalties to an author's literary agent and the agent pays the author. In this case the publisher reports the full amount of the payment on the 1099 to the literary agent. The literary agent must provide the author with a 1099 and also reports the full amount of the payment from the publisher on that information return, even if the literary agent has subtracted his commission before making payments to the author.

In limited situations, taxpayers filing joint federal income tax returns may be relieved from joint and several liability pursuant to Section 6015. Known as innocent spouse relief, the taxpayer must satisfy a number of requirements. In Angela Barriga, f.k.a. Angela Robledo (T.C. Memo. 2004-102) the taxpayer sought innocent spouse relief, arguing that she was divorced and the divorce settlement allocated the liabilities to her former husband. The Court noted that in making a decision it had to look at all the factors and these are the only two that weighed in the taxpayer's favor. The Court noted that she did not show she had no knowledge of the underpayments, that she would suffer economic hardship or that the liabilities in question were actually attributable to her former spouse. The Court denied her relief.

The Jumpstart Our Business Strength (JOBS) bill passed the Senate on May 11. Bill contains a number of provisions, but two obscure ones that are of interest. One would raise the penalties on promoters of abusive tax shelters to 100%. Another second would provide more incentives for whistle-blowers who expose tax fraud.

What to give the IRS a low-ball offer in compromise? You might want to reconsider. In Segundino and Delfa Razo (T.C. Memo. 2004-101) the IRS issued the taxpayers a Notice of Federal Tax Lien Filing listing their total liabilities for three tax years as $7,832. The taxpayers offered to pay $100 to settle the debt. The Appeals officer rejected the offer and sustained the federal tax lien. The IRS recommended the account be suspended as temporarily not collectible because of the taxpayers' age and health. The Court found the IRS did not abuse its discretion in refusing the offer in compromise.

In Joseph M. Grey Public Accountant, P.C., Water Pure Systems, Inc., Mike J. Graham Trucking, Inc. (2004-1 USTC 50,214; U.S. Court of Appeals, 3rd Circuit) the Court affirmed the Tax Court decision (119 TC 121; T.C. Memo. 2003-53; T.C. Memo. 2003-49) that the presidents of the three S corporations were employees of the corporations. The Court noted the individuals all performed substantial functions for the corporations and took distributions from the corporations.

Paid a Deposit Penalty on Form 941? You May be Able to Get a Refund

Been hit with a penalty for failing to deposit taxes for Form 941 lately? The IRS has announced (IR-2004-70) an incentive to encourage enrollment in and use of the Electronic Federal Tax Payment System (EFTPS). Approximately 1 million employers could qualify for a refund of a previously paid federal tax deposit (FTD) penalty. The EFTPS-FTD penalty refund offer allows business taxpayers an opportunity to receive an automatic one-time penalty refund if they have been assessed a deposit penalty on a Form 941, Employer's Quarterly Federal Tax Return. The offer is available to employers who are not mandated to use EFTPS.To qualify for the offer, you must:

• use EFTPS for one year (four consecutive quarters),
  
• make all Form 941 payments on time and,
  
• have previously fully paid the penalty.

"This approach is a sound business decision for both taxpayers and the government," said IRS Commissioner Mark W. Everson. "Using the electronic payment system is much more accurate and much less burdensome for taxpayers. At the same time, the government saves money because there are fewer errors, fewer notices and fewer problems." Using EFTPS eliminates the vast majority of the errors found on paper submissions. These errors on paper coupons result in late or misapplied payments and an FTD penalty. "Paying taxes using EFTPS means almost 20 times greater accuracy," said Dick Gregg, FMS Commissioner. "Greater accuracy means fewer penalties. I encourage individuals and businesses to enroll today and save time and money." Beginning in 2005, the IRS will automatically determine which employers have achieved the four quarters of EFTPS compliance and reverse the most recent full-paid FTD penalty minus any outstanding taxes. No other action by the employer is necessary. The IRS will look back up to four quarters prior to the four-quarter compliance period for a full paid FTD penalty to abate. Penalties paid earlier than one year prior to the four-quarter compliance period are not eligible for the automatic offer. EFTPS is a free service provided by two bureaus of the U.S. Department of the Treasury, IRS and the Financial Management Service (FMS). EFTPS gives businesses, individuals, and tax professionals the ability to make federal tax payments electronically online, by phone or with batch provider software for professionals.

Taxpayers can enroll in EFTPS by visiting EFTPS.gov or by calling EFTPS Customer Service at 1-800-555-4477 to receive an enrollment form by mail. EFTPS was introduced in 1996 and since that time more than 4.6 million taxpayers have enrolled in the system to make their federal tax payments electronically. Taxpayers can make payments through a secure web site or by phone 24 hours a day, seven days a week from home or office; schedule payments up to 120 days in advance (for businesses) and 365 days in advance (for individuals); and review the last 16 months of tax payment history online or by calling Customer Service. In addition, taxpayers receive an immediate acknowledgement number for every EFTPS transaction for easy record keeping and as proof of the transaction. EFTPS is ideal for all business taxpayers and for individual taxpayers that make Form 1040 ES quarterly estimated payments.

Links:

Electronic Federal Tax Payment System--www.eftps.gov
Financial Management Service--www.fms.treas.gov

In Brief:

Previously Reported In Daily Update

Don't chase dividend yield . . . Since they're only taxed at 15% (5% for taxpayers in lower brackets), $1 of dividends is better than $1 of fully taxed interest. But don't buy a stock just because it's got as high yield. Instead, you should be looking for total return--yield plus capital appreciation. Stocks that have a high yield could be vulnerable to a price decline if the dividend is at risk. Be suspicious of stocks with yields that are substantially higher than the average for the market and/or those that have a much higher yield than other stocks in the same industry.

Retrain or fire and hire? . . . If you're dropping a division, product line, service, etc. to concentrate and build up another section of the business, and the surplus workers don't have the skills needed in the new operations, should you try to retrain them or lay them off and hire new workers? There are costs and intangible problems associated with laying off employees only to hire new ones, but that can be much less costly than trying to retrain. If retraining isn't technically or economically feasible, you've got to be careful how you handle the news. Employee morale and the possibility of legal action must be considered. Get good advice before proceeding.

Unused inventory or fixed assets? . . . Take a long hard look at such property. Determine its future. What are the chances you'll sell or use it somewhere down the road? Be realistic. If you're not going to use it, get rid of it. Most property costs money to own. You've got to store it and insure it. Even if you have to take a loss, the money raised from the sale should be more useful elsewhere. In addition to saving on storage and insurance, you may also be saving on maintenance, you could get a tax writeoff and avoid additional personal property taxes. If you do business in more than one state, it could also affect (both positively and negatively) your apportionment factor and your state taxes.

Assumable mortgages . . . Years ago, when interest rates were relatively steady over long periods of time, many mortgages were assumable. That is, instead of the buyer going out to get a new mortgage, he would take over yours. That would mean he'd get the same interest rate and terms. The bank generally had the option to approve the transfer, but the buyer might be able to get financing at a lower rate than the current market. If you're buying a house, check to see if the mortgage is assumable and what the rate is on the seller's mortgage. If you're going for a new mortgage, see if the lender offers an assumable one. With rates almost sure to go up, an assumable mortgage might help sell the house later. The same goes for business property.

Don't cut simply for the sake of cutting . . . There are many areas in which a business can reduce costs. Laying off employees is a big one. Cutting overhead expenses is another. But you shouldn't make the decision based only on the amount to be saved. While laying off Frank could save you $40,000 per year, will that hurt the business? There are two important considerations. First, what does Frank, another employee, a service provided by an outside supplier, etc. provide. If the expense doesn't add to the business and won't negatively affect the business, consider cutting. Second, if the employee, service, etc. is important to the business, can you find a cheaper way to accomplish the same objective?

Answer your phone! . . . Unless you have a very limited number of customers who know you well (e.g., a consultant with only a couple of clients), not answering your phone is a great way to lose business, antagonize vendors, etc. If people don't get through to either you, your secretary, someone else in the office, or voicemail, the first thing they'll assume is that something's very wrong. A customer may think you went out of business; a supplier may think that you're avoiding calls because you can't pay. While voicemail isn't appreciated by many customers, it's better than nothing. Just make sure you get back to them promptly. What about technical problems? Phones can be out for a variety of reasons. One backup plan is to let all your customers know your e-mail address and encourage them to use it (for many purposes it can be more efficient than the phone). If you can justify the cost (and don't have it already), get a pager number for the office. Customers can call the pager number and leave a number. If you have cell phone service, you can return the call on the mobile phone. If it's a widespread outage, the pager should record the messages for later callbacks. These options aren't fool proof, but it's certainly better than just getting customers and vendors mad at you.

Closing the deal . . . Convincing the buyer you've got the best product doesn't mean anything. The proof is in the purchase. Getting the prospect to act now is important, sometimes critical. The longer they put off the purchase, the better the chance he or she will find an alternative, or, in the case of an impulse purchase, another place to put their money. Closing the deal can be critical if you're selling to a business or organization that operates on a strict budget. Money may not be in the budget during the next period for the purchase. Timing can also be critical if you're trying to boost sales during a slow period or just need some extra cash flow. The promotion should make it clear that timing is important. If the prospect fails to act by a certain day, they'll lose the deal. You can do that by a price cut, a premium for ordering now, etc. How you do it often depends on your business.

Bad debt deduction not theft loss . . . Nonbusiness bad debts are only deductible as a capital loss; business bad debts are fully deductible. Theft losses are deductible, subject to the casualty loss rules. In a recent IRS Legal Memorandum (ILM 200406046) the IRS Chief Counsel held that investors who purchased equipment that was to be leased back to the corporation could not claim a theft loss when the corporation declared bankruptcy. The IRS reasoned that a theft loss would only be appropriate if the principals of the corporation fraudulently induced the investors to part with their money, and that did not appear to be the case here. Check all the angles. Investments that may look low risk may not be.

Copy machine leaks . . . Information leaks from computers are well documented. But company info can be stolen from modern copy machines too. Many larger machines contain hard disks and are networked to computers. While that's a big convenience, it can also invite information theft. Talk to the supplier to see how you can protect yourself.

Make customers feel special . . . That's what exclusive restaurants, hotels, etc. do. The special touches allow them to charge more, and that usually translates into substantially higher margins. But the approach shouldn't be limited to those types of establishments. Many businesses can do it. If you have a clothing or other retail store, consider running sales or a showing for just your best customers. Or providing a service (it can be free, for a nominal amount or even full charge) to your best customers only. It's tougher for most service businesses. But you can offer faster or extra services for the same or just a slightly higher price. Small businesses that know their customers by name can offer occasional free services or products. Keeping the customers who shop regularly and/or spend the most money with you will help you maintain a loyal base that will recommend you to others.