News On The Tax Front--The latest tax news.
Trade-Ins--They're an everyday occurrence in business. You trade in a old truck for a new one. But not every trade-in is nontaxable. And often trading in a vehicle or other equipment could be a big tax mistake.
Deducting Mortgage Interest--Interest on a mortgage on your primary and vacation home is usually deductible. But there are a number of tricks, traps and fine points.
Pension Plan Primer--What type of pension plans are available to small businesses? Here's a quick rundown.
Can Your Employees Obligate Your Business? --Don't wait until it's too late to take action.
In Brief:--Tax, business, and personal finance tips.
Previously Reported In Daily Update
Most alimony cases that come to court involve a taxpayer taking a deduction for payments that are challenged by the IRS. In the case of Helen C. Hopkinson the taxpayer argued that the payments she received from her ex-husband should not be included in her gross income since they were not alimony. The Court found that the various payments she was receiving all qualified under the definition of alimony.
If you paid your taxes by credit card, you may have been billed for a 1998 tax underpayment. The IRS announced that there was a glitch in the system. Some 13,700 charge card payments made on April 15 were incorrectly coded as estimated taxes for 1999 rather than as payments for 1998. If you were affected, you don't have to take any action. The IRS will correct the problem automatically. You may want to make sure that your payment has been properly credited. You can call 1-877-754-4413.
And you thought the tax filing season is over. The IRS has announced (Ann. 99-57; May 26, 1999) that some taxpayers who have already timely filed their 1998 federal income tax returns and would like to recharacterize their 1998 IRA contributions, including amounts contributed to Roth IRAs as conversions for which the taxpayers were not eligible (because their modified adjusted gross income exceeded $100,000 or because they were married filing separate). For these taxpayers, the deadline for making the election to recharacterize is 6 months after the unextended due date (i.e., April 15) of their returns. The IRS noted that the regulations generally provide for an automatic extension of 6 months from the due date of a return, excluding extensions, to make elections that otherwise must be made by the due date of the return or the due date of the return plus extensions, provided (1) the taxpayer's return was timely filed for the year the election should have been made and (2) the taxpayer takes appropriate corrective action within this 6-month period. You make the recharacterization by filing an amended return. CAUTION. Make sure your state follows the federal rules.
If you take a job away from home you can deduct expenses incurred away from home only if you are temporarily away from home. If the period away from home is more than one year, the employment is considered to be indefinite and away from home expenses are not deductible. In Hansel Hamlin Johnson, Jr. and Janice H. Johnson (T.C. Memo. 1999-153) the taxpayer had a one year contract. On the last day of the contract it was extended. The Court found that at that time he could no longer expect the employment would last no more than a year.
According to a New York Times article (May 18, 1999) IRS property seizures are down 98% over the last two years. Garnishments and tax liens have also dropped. In an earlier issue we also noted that audits are down. The reason, at least in part, appears to be that the IRS and the agents don't want to test the recently enacted laws designed to protect taxpayers from the Service. The decline might also be due to budget restrictions. Not only has the Service had a tough time getting funding, because of computer upgrading and agent training, it needs funds more than ever.
Beginning with 1999, the home office rules have been materially liberalized. However, in John A. and Margaret R. Gosling (T.C. Memo. 1999-148) the taxpayer managed to secure a deduction for a home office under the old rules. The taxpayer was a music director who used one room of his home for his business activities. The Court noted that the activities performed in the home were important enough and the time spent was significant enough to qualify the space as a principal place of business. Since the home office passed that test, the Court allowed the taxpayer to deduct his car expenses for travel from the home office to the concert hall.
The IRS can, and often does, challenge the validity of a bad debt deduction. In many cases they claim that the debt is not bona fide. That's what happened in the case of August V. and Mary E. Klaue (T.C. Memo. 1999-151). The taxpayer had lent money to an inventor to complete the development of a medical device. The Court allowed a nonbusiness bad debt deduction for amounts the taxpayer advanced the inventor while the product appeared to have a chance of being marketable. On the other hand, advances made after several marketing roadblocks were encountered that severely reduced the chances of financial success, were deemed to by the Court to be bona fide debts.
If an LLC (limited liability company) has only one member, it's treated as a sole proprietorship and you should include the activities on a Schedule C. On the other hand, if the LLC has two or more members, it's normally considered a partnership. In a recent letter ruling (LR 199911033) the IRS held that a 2-member LLC should be treated as a sole proprietorship. Only one of the members had any economic interest in the entity. The member was entitled to all the profits and losses, and, upon dissolution, that member would receive any assets.
In most of the hobby loss cases we review the taxpayer had some argument to support his deduction. In this case (Wilbur Kenneth Griesmer; T.C. Memo. 1999-147) the taxpayer claimed deductions for his meteorite and pyrite collection activities. However, he never received any income, had no records, and could not substantiate any of the expenditures. In fact, the Court believed he didn't have the cash to pay for the expenditures he claimed. In addition to losing the case, the Court sided with the IRS and allowed the negligence penalty.
In Frederick E. Slater (99-1 USTC 50,484; U.S. Court of Appeals, 9th Circuit) the Appeals Court affirmed a Tax Court decision holding that a taxpayer who was criminally punished for tax fraud could also be liable for civil penalties for the same offenses. The Court noted that the Double Jeopardy Clause protects only against the imposition of multiple criminal punishments for the same offense.
An S corporation can have no more than 75 shareholders. But what if you want to set up an employee stock ownership plan? In a recent letter ruling (LR 199906044) the IRS held that the plan, not the participants, was considered the shareholder. Thus, no matter how many participants were in the plan, the plan only counted as one shareholder. In addition, the corporation was considered to have only one class of stock.
If you win a case against the IRS in court and you can show that the IRS was not justified in their position, you may be able to recovery your attorney's fees. In Dudley W. Taylor and Lori F. Fleishman (99-1 USTC 50,472; U.S. District Court, East. Dist. Tenn.) the taxpayers who sought reimbursement were attorneys who won their case against the IRS. The Court denied them reimbursement of a bill from their law firm. It was clear from the record the taxpayers participated in the preparation of the suit and the two taxpayers were the only two partners in the law firm. The Court did allow them reimbursement of $5,850 for fees paid to a CPA as a expert witness.
In all but very tight real estate markets, it's fairly common for a landlord to agree to make tenant improvements or provide the tenant with an allowance to do so. In Gregory H. and Elizabeth A. Price (T.C. Memo. 1999-142) the landlord reimbursed the taxpayers' partnership for improvements the partnership made to the property. The IRS argued that the amounts were taxable income. The partnership was able to show that the payments were simply reimbursements of amounts expended by the partnership and agreed to in the lease. Note. Check with your tax advisor on the best way to handle tenant improvements. There can be important tax consequences. And make sure the lease supports your position.
In addition to the regular tax bill that's in the Congressional hopper, there's an education tax cut package. The bill would expand education IRAs by increasing the annual limit from $500 to $2,000 and allow their use for primary and secondary school costs. In addition, the bill would extend the exclusion for employer-provided undergraduate courses, create tax-free distributions from state prepaid tuition plans, and eliminate the 60-month rule for student loan interest paid.
If you contribute a partial interest in property, for example, through a charitable remainder trust, the valuation is based on actuarial tables that take into account an assumed interest rate and your life expectancy. The IRS has just announced (T.D. 8819) that it revising certain tables used for the valuation of partial interest under section 7520 to reflect the most recent mortality experience available.
A change in your taxable income can have far ranging effects. In Paula M. Kelly (T.C. Memo. 1999-140) the taxpayer's Schedule C deductions were reduced. That increased her taxable income and reduced the amount of her earned income credit. Note. There are now dozens of tax benefits that depend on your adjusted gross or taxable income. A small increase in your adjusted gross income can have significant side effects, particularly if credits are phased out. For example, your AGI for 1999 is $80,000 so you can claim the full Hope credit for your daughter. Now assume the IRS disallows $20,000 of S corporation deductions. Your tax will go up by $5,600. But on top of that you'll lose the Hope credit, a $1,500 tax saving. There are other adjustments (e.g., a higher threshold for medical deductions), and your state taxes will probably go up also.
Personal interest is no longer deductible; interest incurred on a debt related to a trade or business still is. Interest on a tax underpayment by an individual is personal interest and nondeductible. But what if the reason for the underpayment stems from underreporting of income on a Schedule C? You would think that should be a business debt and the interest deductible. Not according to the IRS regulations. And the courts have been as ambiguous as the law. Some side with the IRS, some with taxpayers. In a recent U.S. Court of Appeals case (Richard R. Allen, Sr.; 99-1 USTC 50,470; U.S. Court of Appeals, 4th Circuit), the Court held that the regulations are valid. That is, interest on an underpayment is personal interest and nondeductible, regardless of the source of the tax liability. Now that the Fourth Circuit has agreed with the other circuits, it seems pretty well settled. Note. That doesn't change the deductibility of other business interest. For example, your business, a sole proprietorship borrows money for a truck. The interest on the loan is fully deductible.
If you don't elect to amortize start-up costs or the costs of investigating a business acquisition you can't deduct them until you abandon or sell the new business. In Rev. Rul. 99-23 (I.R.B. 1999-20) the IRS clarified what expenditures will qualify as investigatory costs eligible for amortization. We'll have a complete discussion of this in an upcoming issue.
You've got equipment that's no longer repairable, obsolete, no longer needed in the business, etc. If you sell it for less than your basis you can take a loss. But what if there are no buyers? The law allows you to take an abandonment loss. But you've got to be able to show you actually abandoned the property. Even if you give the equipment to a scrap dealer, get a receipt, describing the equipment and that no funds changed hands. If the equipment is just going into the trash, draft a memo to the person who will take care of it. Better yet, do several items at once put them all in the same memo. Then make sure you send a copy of the memo to accounting so that they can remove the equipment from your books. If the dollar amounts are significant and the equipment must be dismantled, consider videotaping portions of the event. Sound like too much work? In Charles A. Buda and Annette H. Buda (T.C. Memo. 1999-132) the taxpayer was a shareholder in an S corporation that could not prove it had abandoned the equipment in the year it claimed. The Court denied the deduction.
Intercompany transactions are often challenged by the IRS. The Service is looking to prevent taxpayers from shifting income from an entity taxed at a high rate to one taxed at a lower rate. In GAC Produce Co., An Arizone Corp. (T.C. Memo. 1999-134) a corporation received commissions from its subsidiaries for marketing services. The Court sided with the IRS, noting the commission rate did not even cover its fixed costs. That showed that the commission was not determined on an arm's length basis.
If you're a partner in a partnership (or an LLC taxed as a partnership) your basis includes any liabilities of the partnership for which you're responsible. For example, if you're a 20% partner and the partnership has outstanding liabilities of $100,000, you're deemed to be responsible for $20,000. That increases your amount at risk which could enable you to deduct more of the partnership's losses. In Robert S. McDaniel, Jr. and W. Jane McDaniel (T.C. Memo. 1999-133) the taxpayer found out there's a downside. If you're relieved of all or a portion of the liability, you may have to recognize a gain in the year that occurs. In the case, the taxpayer there was a dispute as to the tax year the relief occurred.
The tax shelter days of the 80's may be gone, but that doesn't mean taxpayers aren't using investment schemes to reduce their taxes. In this case (Lowell L. and Marilyn A. Robertson, T.C. Memo. 1999-130) the taxpayers invested in a sham computer sale-leaseback trust. The IRS using Sec. 183, the section that deals with hobby losses. The Court sided with the IRS, agreeing that the transaction was tax-motivated, with no profit objective. Moreover, the transaction lacked economic substance.
Businesses regularly trade in equipment when purchasing new machines, autos, etc. If it were not for a particular Code Section (1031), every trade-in would really be a sale of the old equipment, followed by a purchase. In reality, a trade-in is just a special case of a like-kind exchange, and some complex rules can apply. We won't go through all the like-kind exchange rules here. Instead, we'll concentrate on some trade-in traps.
Before negotiating a trade-in, decide if you want the tax consequences of a trade-in. If you trade in an auto, for example, you usually report no gain or loss on the transaction. Instead, any gain or loss is deferred until the new asset is sold. That may not be what you want.
Example--You purchase a truck for $20,000. After two years your basis in the truck (cost less depreciation taken) is $15,000. Because you put high mileage on it, the truck has a fair market value of only $12,000. If you sell the truck, you'll have a deductible loss for tax purposes of $3,000. Now assume you trade the truck in for a new one costing $23,000. You give the dealer the old truck plus $11,000 cash. Your tax basis in the new truck is $26,000 ($15,000 basis in the old truck plus $11,000 cash paid). You don't get an immediate deduction for the loss, but your basis in the new truck includes the loss not taken. Thus, if you fully depreciate the new truck over five years you'll get $26,000 of deductions.
If you followed the example above, you'd realize that over the long term your deductions are the same either way. However, if you sold the truck you'd get the benefit of the $3,000 loss currently instead of spreading it over five years. With a trade- in, any gain or loss continues to be carried forward with each trade-in until you finally sell the asset. (With luxury cars, the situation is worse because your depreciation deductions are limited.) That's why you've got to weigh any economic benefits of a trade-in against the tax disadvantage of deferring the loss.
The tax benefits of a trade-in are not automatic. The rules require a "like-kind exchange." That means like property for like property. Years ago the rules used to be pretty liberal. That's different now. The asset given up must be in the same general asset class or product class as the asset received.
Asset classes include:
Thus, you can trade in a light, general purpose truck for another light general purpose truck. However, trading in an auto for a light truck would be a taxable transaction. So would trading office equipment (such as a fax machine) for a computer.
Product classes are defined by 4-digit product classes within division D of the SIC codes. Exchanging a printing press for a collating machine would qualify as a like- kind exchange since both assets are used in the printing business. On the other hand, trading in a printing press for a wood lathe would be a taxable transaction.
A transaction can be part taxable and part nontaxable. For example, you trade in a light truck and a car for another light truck. You'd have to recognize gain on the disposition of the car, but not on the light truck. You would also recognize gain if you gave up a truck for another truck, but received some cash in return. The taxable gain cannot be greater than value of the unlike property received. Thus, if you would have a gain of $1,000 on the exchange and only received $250 in cash, the taxable gain would be $250. The other $750 is deferred.
Tax Trap--If you receive unlike property you will have to recognize any gain, but if you have a loss it's deferred. That's a no win situation.Tax Trap--What if you want to recognize the loss but have to dispose of the old equipment? You can't simply sell it to the dealer and purchase new equipment. Even though you claim the sale of the old equipment and the purchase of the new are separate, the IRS will claim that the two transactions are related, and the loss will be disallowed. The safest way around the problem is to sell the old equipment to one party; purchase the new from another. If that's not practicable, sell the property to the dealer, but wait 45 days to purchase the new equipment. Or, purchase the new equipment but wait 45 days to sell the old equipment to the dealer.
If you want to do a like-kind exchange, sometimes a simultaneous exchange isn't possible. For example, the dealer installs a new machine, but you can't deliver the old one to him until a month later. There are two rules here. First, the property to be received must be identified on or before the 45th day after the date on which you relinquishe title to the equipment. Within 45 days, the equipment you will receive must be identified. The second rule is that there is a 180-day time limit on the completion of the exchange. This could be a problem with respect to custom-made equipment.
Another point. Special rules apply if you consummate a like-kind exchange with a related party (e.g., another business you own, or between you and your corporation) and that party sells the property within two years of the exchange.
A simple trade-in of a truck for a truck, auto for an auto, etc. should present no problems. If the exchange becomes more esoteric, such as different types of equipment, multiple exchanges at the same time, or where you receive unlike property in addition to like property, consult your tax adviser before committing.
The housing and home mortgage markets have undergone dramatic changes in the last few years. More families have second homes, houses have increased significantly in price, many small business owners are using home equity loans to finance their companies, some lenders will loan on up to 125% of fair market value, etc. And, while interest on most mortgages is tax deductible, there are some tricks and traps. The article below is a review of the most important points. Special rules apply to mortgages signed before October 23, 1987. Since that's almost 12 years ago, we won't discuss them here.
The general rules are pretty simple. In order to deduct mortgage interest:
Secured debt. You can't deduct the interest on a home mortgage unless the mortgage is secured debt. A secured debt is one in which you sign an instrument (such as a mortgage or deed of trust) that makes your ownership in the home security for payment of the debt, provides, in case of default, that your home could satisfy the debt, and is recorded or is otherwise perfected under any state or local law. These rules apply for both regular mortgages and home equity loans.
This usually isn't a problem with a commercial mortgage. Almost all lenders will require the house be collateral for the loan and will record the deed. However, if you're borrowing from a relative, you're dealing with a lender where you have a long- standing relationship, getting owner financing, or in certain other situations, you might have a tendency to skip this step. Don't. You don't want to lose a big deduction on a formality.
Caution. A wraparound mortgage is not a secured debt unless it's recorded or otherwise perfected under state law.
Tax Tip--You can choose to treat any debt secured by a qualified home as not secured by the home. If you make this election for one taxable year, you must use it for all later years, unless you obtain the consent of the IRS. You may want to make this election if the interest on the debt would be deductible even if it didn't qualify as home mortgage interest. For example, you own a principal residence and a vacation home. You're building a third vacation home. The interest on all three could qualify (were it not for the 2-home limitation) as home mortgage interest. But all the interest on your current vacation home is deductible because the full amount of the loan proceeds were invested in your business.
Qualified home. The mortgage must be on a qualified home. That means your main home or your second home. A home includes a house, condominium, cooperative, mobile home, boat, or similar property that has sleeping, cooking, and toilet facilities. Your main home is generally the home where you spend most of your time.
If the second home is not rented out, or, if rented out, you use it for more than 14 days or more than 10% of the number of days during the year that it's rented at a fair rental (whichever is longer), it qualifies as a second home for the mortgage interest rules.
The only part of your home that is considered a qualified home is the part you use for residential living. If you use a portion of the home as a home office, you must allocate the use of the house. Divide both the cost and fair market value of your home between the part that is a qualified home and the part that is not. Dividing the home will affect your cost will limit your home acquisition debt, since that's limited to the cost of the home plus the cost of any improvements. Dividing the fair market value may affect your home equity debt limit.
On the other hand, the portion of interest that might be disallowed because of these limits might be deductible as interest on the portion of the home office.
Caution--You could lose a deduction for the interest on the home office portion since any deduction for your home office is limited to the income from your business. While the deduction can be carried forward, it could be lost if you abandon the business before deducting the amounts carried forward. Work through the numbers carefully before deciding on whether or not to take a home office deduction.
If you rent out a portion of your home, you can still treat that part as used by you for residential living if the space is used by no more than two tenants, the rented portion is not a self-contained unit with separate sleeping, cooking, and toilet facilities, and the rented portion is used primarily for residential living.
You can treat a home under construction as a qualified home for a period of up to 24 months, but only if it becomes your qualified home at the time it is ready for occupancy.
You can continue to treat your home as a qualified home even after it is destroyed in a casualty. But, within a reasonable period of time you must rebuild the destroyed home and move into it or sell the land on which the home was located. This rule applies to both a first and second home and whether or not the home is in a federal disaster area.
You can also treat a home you own under a time-sharing plan as a qualified home if it meets all the requirements.
What qualifies as interest? In addition to what the bank calls interest, certain other payments on a mortgage can also qualify as interest.
Late payment charges are considered interest if they are not for a specific service performed by the mortgage lender.
Mortgage prepayment penalties (penalties made for paying off the mortgage early) are deductible as interest.
If you sell your home you can only deduct the interest on the mortgage up to, but not including, the date of the sale.
If you pay points to obtain a home mortgage, the full amount of the points should be deductible up front. This general rule only applies to mortgages used to purchase or improve your main home. Points paid for a home equity loan or to refinance an existing mortgage must be amortized over the life of the loan. The rules are actually more complex. We'll discuss points in more detail in our next issue.
Tax Tip--Banks and other lenders are required to give you a Form 1098 showing the amount of interest you paid during the year. Generally, the form will only include points that you can fully deduct in the year paid. If you paid points on a home equity loan, second home, or refinancing, the points are amortizable but won't be reported on the 1098.
If you and at least one other person (other than your spouse if you file a joint return) were liable for and paid interest on a mortgage that was for your home, and the other person received a Form 1098 showing the interest that was paid during the year, attach a statement to your return explaining this. Show how much of the interest each of you paid, and give the name and address of the person who received the form. If you are the payer of record on a mortgage on which there are other borrowers entitled to a deduction for the interest shown on the 1098, deduct only your share of the interest.
Limits on home acquisition debt. Generally, there are two limits on the amount of home acquisition debt. The first is that the amount of the mortgage can't exceed the cost of the home plus the cost of any substantial improvements. Second, the total home acquisition debt you can have at any time on your main and second home can't be more than $1 million ($500,000 if married filing separately). In addition to these limits, you can have up to $100,000 of debt that qualifies as a home equity loan.
Example--You purchase a home for $200,000. Because the home is undervalued, the bank lets you borrow $225,000. Only 88.88% of the interest ($200,000 divided by $225,000) would be deductible. (The excess may be deductible as a home equity loan; see below.)
If you refinance existing home acquisition debt, it will also qualify as home acquisition debt. However, the new debt will qualify only up to the amount of the balance on the old mortgage prior to refinancing.
Example--You have an existing mortgage for $200,000. The price of the house has risen substantially and the bank allows you to refinance for $250,000. Only 80% ($200,000 divided by $250,000) of the interest would be deductible. (Again, the excess may be deductible as a home equity loan.)
Mortgage qualifying later. If the mortgage doesn't qualify as acquisition debt when you sign, it may qualify later. For example, you borrow $100,000 from your parents to buy a new home. For whatever reason, you don't secure the debt. A year later you rectify the error. The mortgage will qualify at that time.
Mortgage and home purchase don't coincide. Normally, the mortgage is effective at the same time you take title to the home. But not always. Maybe you have the funds to purchase the home outright, but want to recover that cash for use in your business. Or you're building the house over a period of time. The mortgage will be qualified acquisition debt if:
Example--You bought a new main home on July 1 for $200,000. You paid for the home with cash from the sale of your old home. On August 15 (within 90 days) you take out a mortgage for $175,000 and loan the money to your daughter's new business. Because you took out the mortgage within 90 days, you can treat it as if you used the mortgage to purchase the home.
Tax Tip--This is an important point. If you don't borrow the money within 90 days, any mortgage (unless it falls under one of the other rules) won't qualify as acquisition debt. It might qualify as home equity debt, but your total home equity debt is limited to $100,000.
Example 1--Fred and Susan build a home on land they own. They begin construction on January 1, 1999 paying for the construction with their own funds and a bank bridge loan. The house is completed on June 1, 2000 at a cost of $200,000. On July 15, 2000 they take out a mortgage secured by the property for $200,000. The entire mortgage qualifies since it was taken out within 90 days after construction was completed and all the costs were incurred within 24 months.
Example 2--Assume the facts are the same as above, but there's a delay in construction and the house isn't completed until March 1, 2001. Only the expenses incurred in the 24 months prior to March 1, 2001 are allowed. Assume those expenses total $180,000. That would be the maximum mortgage that qualifies as home acquisition debt.
If you take out a home improvement loan to finance construction costs for a large job, the bank will often control disbursement of the funds and will want a progress report from the contractor. If that's the case, you should have no problems. However, if the bank advances the funds directly to you, you'll have to be able to trace the use of the funds to the project. Again, that may not be much of a problem if the funds are deposited in your account and the contractor begins work immediately. But the debt may not qualify if you receive the funds and the contractor doesn't begin work on the project for some time.
Tax Tip--If you're building or substantially improving a house, you might want to talk to your tax adviser. There are some tricky rules. For example, when is the house complete? It's when it's available for occupancy. Generally, that means you have to have a certificate of occupancy from the town, the electric must be hooked up, etc.
Qualifying home improvement costs. Only the cost of capital improvements, not repairs, qualify as the cost of building or substantially improving your home. For example, adding a room to your house or redoing your kitchen would qualify. Painting the house would not; unless the painting is part of a renovation that substantially improves the home.
$1,000,000 limit. Only the first $1 million of loans qualify as acquisition debt. Thus, if the mortgage on your main residence is $750,000 and you take out a mortgage on a vacation home for $500,000, only 80% of the interest ($1,000,000/$1,250,000) would be deductible.
Home equity debt. If the interest doesn't qualify under the home acquisition debt rules above, it may be deductible as home equity debt. The rules are easier here. Any debt that is secured by a qualified home, that could be your main home or a second home, qualifies. However, the deductible interest is limited to the amount of the debt that is $100,000 or less.
There is a second possible limitation here. The debt can't exceed the total of each home's fair market value reduced by the amount of the home acquisition debt. You don't have a problem if the lender restricts the loan to the fair market value of the house. However, if they offer to loan you up over 100% of the market value, you could have a problem.
Example--The current fair market value of your home is $220,000. The balance on your original mortgage is $190,000. A lender is offering you a loan equal to 125% of the value of your home. You take out an $85,000 loan ((125% X $220,000) - $190,000). The home equity debt is limited to $30,000 ($220,000 FMV - $190,000). Only about 35% of the interest would be deductible.
Other points. If you're doing a refinancing, you can't extend the term of the loan beyond the term of the loan being refinanced. For example, if the remaining term of the original loan was 14 years 6 months, the refinancing can't be for more than that period.
If the mortgage debt exceeds the limits, you must allocate the interest among the loans. There are two approaches, the simplified method and the exact method. Talk to your tax advisor for details. You may be able to deduct more interest by selecting one method over the other.
While the interest may be deductible for regular tax purposes, it may not qualify for alternative minimum tax purposes. The rules can be tricky here. Generally, interest on a home equity loan isn't deductible, nor is interest on a boat, a mobile home used on a transient basis, or a refinancing done after July 1, 1982 to the extent that the refinanced amount exceeds the original loan.
You may not want to take out a home equity loan for business use just to get a deduction. The interest on a regular loan may be deductible. That's true if you borrow money to purchase an interest in a partnership, LLC, or S corporation. Also, if you borrow money and loan it to your business, the business should pay you interest. If that's the case, you have investment income. You can deduct investment interest expense up to the amount of your investment income.
Example--You borrow $100,000 and loan it to your C corporation. The interest expense is $9,000 for the year. The corporation pays you $6,000 in interest. In addition, you have $2,800 in dividend and interest income from other investments. $8,800 of the interest expense is deductible since you have that much in investment income ($6,000 plus $2,800).
Final remarks. As with many of the tax laws, if you keep it simple, the law is simple. Get tricky and you've got to do your homework. A bank loan to purchase a main home for no more than the fair market value of the house requires no research. On the other hand, if you're building your home, doing a refinancing, etc., check the rules before committing.
We've had a lot of questions on pension plans. That is, what type of plans are available to small businesses? What are the major rules and restrictions? How do you implement them? There are a number of misconceptions. The discussion below is not an exhaustive treatment of the topic. We're just
hitting the highlights of what's available to small business owners. You're probably familiar with some of the options. Talk to your tax or financial advisor before proceeding. Except for IRAs, almost all other plans require a commitment. You don't want to set up a plan for just one year. And, in some cases you can't. One more thing. There can be variations on many of the plans described below.
Deductible IRA. You get a deduction up front, but will have to pay taxes when you draw down the money. It makes sense if you're in a high bracket now, but expect to be in a lower one when you retire. It can also make sense if your income fluctuates widely so that you can get a deduction when you're in a high bracket. The maximum contribution for all IRAs combined is $2,000 annually. Your contribution to a deductible IRA is limited if your AGI is over $51,000 (married, filing joint, 1999 amount) and you're covered by a pension plan. If your spouse, but not you, is covered by a plan, you can have AGI of up to $150,000 and still make a full contribution.
Nondeductible IRA. No deduction, but the money grows tax free until you take it out and other than a $2,000 limit, there are no restrictions on contributions. Makes sense if you're in a high bracket today and want to shelter earnings until you retire. If you've got extra money and can't contribute to any other type of IRA, it should be considered.
Roth IRA. No deduction, but the money grows tax free and if you meet the requirements, the earnings can be tax free when you take distributions. There are also some estate planning benefits and you don't have to start taking distributions at age 70-1/2. The big restriction? You're contribution is limited if your AGI exceeds $150,000 (married filing joint) or $95,000 for single individuals. If you qualify, a Roth is preferable to a nondeductible IRA.
Qualified plans. This isn't any particular plan, but applies to a range of plans that qualify for special treatment under the law. Unless noted, all the plans below are qualified plans. The big plus? You can make larger contributions than to many other plans. And contributions are immediately deductible by the company, but the contributions and earnings on plan assets aren't income to you or your employees until distributed, for example, at retirement. The big negative? If you have employees you have to cover them (you can exclude some employees, such as those with less than 3 years of service in some cases) and you can't discriminate in favor of highly compensated employees. In some cases these plans can be costly to administer.
SEP Technically known as a Simplified Employee Pension. Can be instituted by an employer for his employees or started by a self-employed individual. Basically, an employer sets up an IRA and makes contributions to that IRA for each employee. Annual contributions are limited to 15% of the employee's pay, but no more than $24,000 (1999 amount). The big advantage is the simplicity. The plan document is a one page form which you can get from the IRS. Cost to set up? Almost nil. Disadvantage? All employees are fully vested immediately.
SARSEP. A salary reduction SEP. You can't start a new one, but if you've got an existing one, you can continue to contribute to it.
SIMPLE IRA. This one's fairly new. The basis of the plan is usually elective contributions by the employee. That is, the employee agrees to contribute a portion of his salary to the plan. Elective contributions are limited to $6,000 (1999 amount). Again, simplicity is the big advantage. The plan is simple and prototypes are available from the IRS. The top heavy plan rules don't apply. That makes it easy to administer. The disadvantage is that the employer must make nonelective contributions of 2% of compensation for each employee eligible to participate. CAUTION. Distributions within the first 2 years are subject to a penalty tax of 25%.
SIMPLE 401(k). Similar to a 401(k) plan. That is, the employee elects to defer part of his salary to the plan. The employer must make a matching contribution or a nonelective contribution equal to 3% of the employee's salary. The big advantage? Simplicity, particularly the fact that the top heavy rules (relating to highly compensated employees) and the average deferral percentage test don't apply. Employee deferrals are limited to $6,000 (1999 amount).
401(k). Again, the basis is an elective deferral by the employee of a portion of his or her salary. The limit on deferrals here is $10,000. That's a significant advantage over SIMPLE plans. And employees can borrow from the plan and hardship distributions are allowed. Contributions by the employer are allowed, but not required. The big disadvantage is there is no standard plan. You may be able to get a prototype, but there could be a significant cost associated with it. In addition, the rules can be very complex. There are a number of tests for discrimination and testing to make sure you're in compliance can be expensive. And, if lower level employees don't defer any of their salary, or their deferral percentage is low, deferrals by higher paid employees can be limited to much less than the $10,000 amount. But perhaps the biggest disadvantage for a small company is the cost of setting up and administering the plan. That may be offset by the amount that can be contributed if all the employees contribute the maximum, or are management employees.
Defined benefit plan. This used to be the most popular plan, particularly for larger companies. Employees are guaranteed a specific benefit at retirement. For example, 1% of compensation for each year of service, 25% of the average of the last 3 years of service, $1,000 a month, etc. There are two advantages to these type of plans. First, the employee knows in advance the amount of the benefit. Second, if the plan is established only when owner/employees are older (say over age 45), the benefits for them can be much larger than for other types of plans. That will also require larger contributions, and, thus, deductions for the business.
There are several disadvantages. First, such plans are more difficult to set up and administer. Annual contributions aren't based on a simple percentage, but on the age of the employee, the number of years to retirement, anticipated life expectancy after retirement, and the projected income from plan. Thus, if the plan is invested in the stock market and it returns 25% per year, the employee's benefits will remain the same, but the company's contributions can be reduced.
For smaller businesses, such a plan only makes sense if the owners are older and most employees are very young. There are several variations on defined benefit plans.
Defined contribution plan. Here there's no promise of any specific benefit in the future. Rather, the company, the employee, or the company and the employee together, make fixed contributions (usually based on a percentage of compensation) to the plan annually. A separate account is kept for each employee. When the employee retires, he gets whatever is in his account. Forfeitures by other employees can increase the amount in the plan. The amount in the plan will consist of the contributions increased by any earnings, or decreased by any losses.
Defined contribution plans can be profit-sharing, money purchase, stock bonus, or employee stock ownership plans. They are much easier to set up and administer than most of the other types of plans (with the exception of SIMPLE and SEP plans). A number of mutual fund companies, brokerage houses, etc. have prototypes that you can fill out by yourself or with the aid of your accountant or tax adviser.
There are two limits on contributions to defined contribution plans. First, contributions for any employee can't exceed $30,000 (1999 amount) per year. Second, only the first $160,000 (1999 amount) of compensation can be taken into account when computing contributions for an employee.
See below for additional information.
Profit-sharing plan. This is a type of defined contribution plan. It's called a profit-sharing plan because years ago contributions were based on company profits. That's no longer true. Even if the business has a loss you can make contributions.
Contributions are based on a fixed percentage of employees' compensation. Thus, if the plan calls for contributions of 15% of an employees' salaries and Fred Flood has $60,000 of compensation for the year, your contribution to the plan for Fred would be $9,000.
You can contribute up to 15% of an employee's compensation, but includible compensation is limited to $160,000 (1999 amount). Thus, the maximum contribution for any employee would be $24,000. The percentage of compensation amount can be reset each year.
Money-purchase plan. This type of plan is similar to a profit-sharing plan described above. However, the maximum contribution can be 25% of compensation. A money-purchase plan is subject to some of the rules that apply to defined benefit plans. Of particular importance is the minimum funding requirement. That is, unlike a profit-sharing plan, you can't easily reset the amount of the contribution. You can get around this restriction, in part, by combining a money-purchase and profit-sharing plan. For example, a 15% profit-sharing plan and a 10% money-purchase plan. Using this approach you can contribute up to 25% of an employee's salary. But there's an overall limit of $30,000 (1999).
Keogh plan. This is just a special name for a plan that covers one or more self-employed individuals. For example, sole proprietors, partners and members of an LLC. The plan may be a profit-sharing, money-purchase, or defined benefit pension plan.
While for employees the same contribution limits apply (i.e., 15% for profit-sharing and 25% for money-purchase plans), the definition of compensation is different for self-employed individuals. That will limit your maximum contribution to somewhat less than 20% of your earnings.
ESOP. It stands for employee stock ownership plan. Basically, a type of defined contribution plan where the contributions are invested primarily or solely in the stock of the employer. Because the plan invests in the company's stock, it's available only to a regular or S corporation.
ESOPs are decidedly different than other types of plans. They're not for everyone. The big disadvantage is the potential loss of control over your company. On the other hand, it may be a way to distribute stock, particularly if you're older and your heirs have no interest in your business. Finally, an ESOP can be an excellent financing vehicle for your business and there are a number of tax advantages.
Nonqualified deferred compensation. You can set up a nonqualified deferred compensation plan for one or more employees. If the plan is unfunded, that is, the company doesn't set aside monies in a separate trust, annuity, etc. but, rather the monies are part of the company's general funds and the employee is not vested in the plan, the company gets no deduction and the employee has no income until he receives the funds. On the other hand, if the plan is funded, the company gets a deduction to the extent of the contribution, but the employee has a corresponding amount of taxable income.
Since none of the tough nondiscrimination rules apply, nonqualified plans are often used as an adjunct to a qualified plan for highly compensated employees, and employee/owners. For owners, it's an additional way of providing retirement benefits, particularly if the company doesn't maintain a regular plan. Without such a plan, if an owner/employee retires, the company would get no deduction for subsequent payments. That is, the payments wouldn't be deductible as salary.
Other points. This is a complex topic. If you think one of the plans above might be useful to you, contact your accountant, tax or financial adviser. We'll be discussing some of the plans above in more detail in upcoming issues.
Can Your Employees Obligate Your Business?
Contracts, expressed or implied, are entered into every day. An employee may call up the local office supply company and order copier paper, or he or she could send a purchase order to a major vendor for a year's supply of components. The employee does not have to be an officer of the company to bind your business. Most of the time there is no problem. From the vendor's standpoint, as long has he has a signed contract in hand, he's satisfied.
In most cases, particularly in smaller companies, the authority given the employee is not in writing, but implied from the day to day nature of the job or prior experience. For example, when you first hired your secretary you told her to order supplies. After a while she made the decisions on her own. Since you didn't object, she has implied authority.
It's assumed that officers have actual authority to bind the company, at least in their area. For example, a personnel V.P. generally has authority to hire new employees.
Only infrequently do problems arise with implied authority. However, you may want to protect the company against a gross error or an unscrupulous employee. You can't keep tabs on everyone. There are some alternatives, however. One way is to require that all purchases over a certain dollar amount be evidenced by a signed purchase order. If you stick to that procedure, vendors will question an order where there is no signed purchase order. If there is no signed order and the vendor ships the goods, you may be able to shift the blame to the vendor.
You can increase your control by requiring that all purchase orders over a certain dollar amount, or all orders for certain goods or services, require two signatures--the employee responsible for cutting the order and an officer. The rules can be printed right on the purchase order. For example "All orders involving goods or services for $5,000 or more require two signatures."
In a hurry? The order can be placed verbally and followed up with a written purchase order. Or the P.O. can be faxed later.
Make sure you enforce the rules. If an employee violates his or her authority, they should at least be reprimanded and the incident noted in their personnel record. You may also want to inform the supplier that they should ship only on a written purchase order signed by certain officers. And, if someone who had authority to obligate the company leaves, you should inform your suppliers. The same rules can apply to other employees. For example, a salesman might be limited to accepting orders up to $5,000. Larger orders require the approval of the marketing manager.
Previously Reported In Daily Update
Media relations . . . Do you have someone in charge of media relations? Firm too small? Or you don't deal with the public? You should have some sort of contingency plan. You don't know when you'll be called on for a statement. It could be a fire in an adjacent store, the heroic act of an employee, the local newspaper or tv station soliciting your opinion, or, hopefully not, a disaster in your business. You want to be able to deal with the situation honestly, but control any damage or take advantage of an positive publicity. Perhaps you or your second in command is the logical choice for a spokesperson. Whoever is in charge, make sure they are prepared with certain basic facts about the company and know generally how much information to release and when to stop. You can't be prepared for every eventuality, but any preparation will allow you to handle the situation better.
Fraud . . . That's the charge facing over 30 small business owners in the New York area. A loan broker induced them to file false tax returns and/or financial statements in order to get bank loans. It's not worth the chance. And if the loan broker is willing to cheat the bank, why would he be honest with you.
Y2K . . . Some experts have suggested that bootleg software may be more susceptible to Y2K problems. We're not voicing an opinion. However, if you're using computers to run your business you should be particularly careful about 'borrowed', counterfeit, or bootleg software. If your machines are networked, you should be even more careful. Back up data files regularly and don't let employees load software from home on your computers. Finally, get the latest virus programs and use them regularly, especially if you use the internet.
Ever consider advertising on TV? . . . That's not as far-fetched an idea as it may sound. If you're selling a consumer product with a broad market and you're in a smaller city, a TV ad may be cost effective. Like radio stations, many TV stations in smaller markets can produce the commercial. They may even do it for free if you purchase enough air time. Cable TV may be even cheaper. In some markets a 30-second spot could cost less than $50. These guidelines won't apply in the big city, however. And, keep in mind that not all products or services do equally well on TV.
Capital gain deferral on business sale . . . For federal purposes you may be able to exclude the gain on the sale of a closely held business if you purchase a qualifying interest in a new business within a certain time period. That can result in big tax savings. Now at least one state, New York, also provides such a deferral. The rules are slightly different than the federal, but most small business owners should qualify. Check the rules in your home state to see if there are similar benefits.
Transfer to family limited partnership is taxable gift . . . In a field service advice memo the IRS held that a mother's transfer of control of a business to family members resulted in a taxable gift. The mother owned a controlling interest in a real estate holding corporation, while her daughter, son-in-law and grandchildren owned minority shares. The shareholders exchanged their stock for units of a newly created limited partnership whereupon the corporation distributed assets to the partnership and liquidated. The mother received limited partnership units in exchange for her controlling interest in the corporation, but the others received general partnership units. The transaction shifted control of the business from the mother to her family (a general partner has control; a limited partners doesnt'), decreased the marketability of her share of the business, and reduced the value of her estate by the time of her death. The taxpayer asserted alternative theories for the transaction, but all resulted in additional taxes. Be careful when engaging in any sort of 'reorganization' such as the issuance of preferred stock for common, voting for nonvoting, transferring shares in a corporation for a limited partnership interest, etc. If rights in the new ownership position aren't equal to that in the old entity, a taxable transaction can result. (Note. While field service advice issued by the IRS has no precedential value, it's a good indication of IRS thinking on an issue.)
Telephone time . . . Telephones can be a big time waster. If you answer your phone whenever it rings, the interruptions can play havoc with your work schedule. Getting back to a challenging project after a phone call can take some time. Consider not answering your phone during certain times of the day. For example, if you work best in the morning, have your secretary or voice mail pick up until, say 11:00. Then return the calls just before lunch or in the afternoon. Another trick. Call just before noon or after 4:00 in the afternoon. The other party will probably hurry the call to get to lunch or get home in the afternoon.
Speed check processing . . . Your regular mail probably contains a load of junk mail, correspondence, etc. as well as checks from customers. Sorting through the mail takes time. In addition, if you get your mail late in the day, by the time you get to the checks, it may be too late for a bank deposit. Consider a post office box solely for remittances from customers. You can check the box more than once a day to insure you get checks in to the bank as quickly as possible. The downside is that it will cost to send someone to check the box. The idea makes sense if your daily cash inflow is substantial. It's particularly important if customers tend to pay near the end of a cycle and paying the suppliers on time is tough. There's another advantage to a separate P.O. box. You can keep better control over incoming checks. That can reduce the possibility of fraud by an employee.
Doing a direct mail test? . . . Small businesses want to keep costs low. So why not do a direct mailing with only a 1,000 pieces as a test? Because the results will probably not be valid. Most direct mail campaigns have a response rate hovering around 1%. On a 1,000 piece mailing that would result in just 10 responses. Most direct mail specialists believe that's statistically too small to be meaningful. Most consider a 5,000 piece mailing to be the minimum.
Severance payments taxable to state where you worked . . . You've been 'downsized' or a merger has left you with a golden parachute. These payments can be several times your annual salary. You might consider moving to a state with lower taxes before you receive the payments. That may or may not allow you to avoid taxes in the state where you used to work. New York State has held that a lump-sum payment received for agreeing to relinquish any claims the employee had relating to his former employment were taxable to New York. Since the tax consequences can be significant, check with your tax advisor before cutting a deal. You may have options, if you plan ahead.
Bribes and kickbacks . . . In field service advice, the IRS held that a taxpayer's expenditures for entertainment and gifts given to government employees were illegal bribes. Illegal bribes and kickbacks are not deductible. While field service advice issued by the IRS has no precedential value, it shows IRS thinking on an issue.
Copyright 1999 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