Small Business Taxes & Management

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

Jobs and Growth Tax Relief Reconciliation Act of 2003--Part III--The final edition of our update on the new tax law. This one covers the new rules on dividends and capital gains.

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

News On The Tax Front

Previously Reported In Daily Update

The House has approved a bill that would create health savings accounts (HSAs) and health savings security accounts (HSSAs) for unisured and employer-sponsored health plan participants. Contributions to the plan by individuals would be tax deductible; employer contributions would be tax free to the employees.

Whether or not you can secure a deduction for legal expenses (often you may be required to capitalize the expenditure), can be a difficult call. In Jesse Emmit Rupert and Marjorie A. Rupert (2003-1 USTC 50,486; U.S. Court of Appeals, 5th Circuit) the Court sided with the IRS in disallowing the taxpayers were not entitled to deduct, as businesses expenses, legal fees incurred by their daughter, but paid for by the taxpayers, in her domestic relations litigation.

In the wake of September 11, 2001, the tax law was changed to provide for a first-year 30% additional depreciation allowance for assets placed in service after September 10, 2001. Taxpayers could elect not to take the additional depreciation. There was considerable confusion and the IRS extended the deadlines for making certain elections. The IRS (Rev. Proc. 2003-50; IRB 2003-29) is now providing additional relief. The current revenue procedure amplifies and modifies Rev. Proc. 2002-33 (IRB 2002-20) by extending the relief provided there to any taxpayer that time filed its 2000 or 2001 return for the taxable year that included September 11, 2001. Specifically, taxpayers who did not elect the 30% additional depreciation, may do so by filing an amended return (several other options are also available). This revenue procedure also permits an automatic extension of time to allow certain taxpayers to change their selection of Sec. 179 property for the taxable year that included September 11, 2001.

Rev. Proc. 2003-51 (IRB 2003-29) sets forth guidelines for use by taxpayers and Internal Revenue Service personnel in making fair market value determinations for inventory items acquired when a taxpayer purchases the assets of a business for a lump sum or a corporation acquires the stock of another corporation and makes an election pursuant to Sec. 338 with respect to the acquisition. This revenue procedure modifies, amplifies, and supersedes Rev. Proc. 77- 12.

Rev. Proc. 2003-48 (IRB 2003-29) modifies and amplifies Rev. Proc. 96-30, which sets forth in a checklist questionnaire the information that must be included in a request for a ruling under Sec. 355. In addition, this revenue procedure modifies Rev. Proc. 2003-3, which sets forth the areas of the Internal Revenue Code under the jurisdiction of the Associate Chief Counsel (Corporate), the Associate Chief Counsel (Financial Institutions and Products), the Associate Chief Counsel (Income Tax and Accounting), the Associate Chief Counsel (Passthroughs and Special Industries), the Associate Chief Counsel (Procedure and Administration), and the Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities) relating to issues on which the Internal Revenue Service will not issue letter rulings or determination letters.

The IRS doesn't have to accept your offer in compromise (an offer to settle your taxes for less than the full amount) if you don't meet all of the Service's criteria. In Silvia S. Rodriguez (T.C. Memo. 2003-153) the IRS refused the taxpayer's offer because the individual had not filed all the tax returns she was required to file. The Court sided with the IRS.

If you're covered by a pension plan and your income is above the threshold, contributions to a deductible IRA are phased out. In Susan L. Rosetti (T.C. Memo. 2003-157) the taxpayer claimed to have made a $2,000 deductible IRA contribution. The Court found the contribution was made to the taxpayer's Keogh plan instead. However, the taxpayer had no self-employment income during the year, making the contribution nondeductible. The Court also held that the taxpayer could not make a deductible IRA contribution since she was an employee of the state and covered by a plan during a portion of the year at issue.

The IRS has issued proposed regulations (REG-106736-00) relating to the definition of liabilities under Section 752. These regulations provide rules regarding a partnership's assumption of certain fixed and contingent obligations in exchange for a partnership interest and provide conforming changes to certain regulations. These regulations also provide rules under Section 358(h) for assumptions of liabilities by corporations from partners and partnerships. In addition, this document provides notice that the IRS intends to issue supplemental guidance that may apply certain of the rules outlined in these proposed regulations to transactions involving corporations.

Distributions from retirement plans before reaching age 59-1/2, unless an exception, such as disability, applies, are taxable income and subject to a penalty tax. Most taxpayers are aware of the rules, at least in general. But, the law considers pledging a retirement account, i.e., using it for collateral on a loan, as a distribution. In Larry D. Armstrong and Coleen Armstrong (2003-1 USTC 50,473; U.S. District Court, Dist. N.D., Northwestern Div.), that's what the taxpayers did. However, they claimed that the loan was void because of a mutual mistake in pledging the husband's retirement account as collateral. The Court found the contract valid and the amounts were considered a taxable distribution.

In In the Matter of the Estate of James Lee Williamson (2003-1 USTC 50,481; Iowa District Court, Polk County) the taxpayer argued that the IRS's claim against the estate was time barred because under state law creditors of the estate have only 4 months from the publication of notice to creditors or one month from actual notice to file claims against the estate. The Court agreed with the Service's argument that case law clearly establishes that state statutes of limitation do not bind the U.S.

If you lost money in a tax shelter scheme, you may be able to claim a theft loss. That's what the taxpayer tried to do in River City Ranches #1 Ltd. (T.C. Memo. 2003-150). The Court held the partnerships were not entitled to theft loss deductions. The Court noted there was no evidence of a theft loss at the partnership level. The tax matters partner (TMP) who was convicted of tax fraud defrauded the individual investors, not the partnership.

Research and development expenditures qualify for special treatment under the law. Without Sec. 174, you would have to capitalize the expenditures. (Section 41 provides a credit for taxpayers increasing expenditures over a prior year.) One of the requirements of the law is that the expenditures must be in connection with your trade or business. That is, if the expenditures result in a product that you manufacture and sell in your business, you can deduct the expenditures. If you don't intend to enter into a trade or business with the developed technology but simply sell the rights to the product, you can't claim the beneficial treatment. In David M. Saykally, et ux. (T.C. Memo. 2003-152) the taxpayer entered into an agreement with another party to create the technology and license it to the other party in exchange for royalties. The Court found the IRS was correct in finding the expenditures did not qualify for expensing under Sec. 174.

The IRS doesn't have to allow any deductions in excess of what you can support by your records, even when it comes to cost of goods sold. In Alber I. and Georgette H. Said (T.C. Memo. 2003-148) the Court allowed as deductions only the amounts allowed by the IRS. In addition, the Court held that the taxpayers had stipulated as to the amount of unreported gross receipts for the years at issue. At trial they claimed they did not stipulate to the amounts, but signed the statement at the direction of the IRS attorney. The Court did not relieve them from the stipulation. Finally, the Court found the taxpayers liable for the fraud penalty because they did not cooperated with the IRS, gave inconsistent answers, made false statements and did not maintain accurate records.

The Tax Court doesn't impose the delay penalty lightly. In David J. Edwards (T.C. Memo. 2003-149) the Court imposed the penalty where the taxpayer advanced frivolous and groundless arguments despite the Court's warning that his arguments had no merit. The Court also took into account the Service's expenditures of time and resources and the taxpayer's conduct during proceedings.

You may be able to have a third-party summons for bank or other records quashed by going to court, but it's not easy. In Nina M. Najjar and James Banks (2003-1 USTC 50,470; U.S. District Court, So. Dist. Ind., Indianapolis Div.) the taxpayers, both attorneys, sought to have a third-part summons quashed, arguing that the state's professional responsibility rules state that a lawyer shall not knowingly reveal a confidence or secret of a client. The taxpayers contended that compliance with the summons would breach client confidentiality by revealing client names, amounts paid to petitioners, and client account numbers. The Court did not agree, holding that there is no legitimate expectation of privacy in the contents of checks, deposit slips or bank statements in a bank's possession. Checks are negotiable instruments used in commercial transactions, voluntarily conveyed to banks, and exposed to the banks' employees in the ordinary course. Case law establishes that petitioners' bank records are not protected by the attorney-client privilege.

For certain accounting method changes within the inventory price index computation (IPIC) method of accounting for last-in, first-out (LIFO) inventories, Rev. Proc. 2003-45 (IRB 2003-27) waives the 5-year prior change scope limitation in section 4.02(6) of Rev. Proc. 2002-9. The IPIC method provides special, elective pooling rules for LIFO inventory items.

The IRS is always on the lookout for home businesses where taxpayers are not in the activity for a profit but really just using the business as a way to write off expenses. In Jorge N. and Vivian Lopez (T.C. Memo. 2003-142) the taxpayers operated an Amway distributorship, but incurred losses for four years in a row. The Court found the taxpayers did not have a profit motive for the activity. Rather than trying to make a profit on the products, they sold the products at cost to try and generate a high enough sales volume to qualify for bonuses. The Court noted that while the taxpayers kept records, it appeared they did so solely for substantiating their deductions, not as a tool for the operations of the business.

The Conservation Reserve Program (CRP) is a small watershed program administered by the Secretary of Agriculture that is substantially similar to the type of programs described in IRC Sec. 126(a)(1) through (8). In Rev. Rul. 2003-59 (IRB 2003-24) the IRS held that all or a portion of cost-share payments received under the CRP is eligible for exclusion from gross income to the extent permitted by Sec. 126. Rental payments and incentive payments are not cost-share payments and are not excludable from gross income.

Just because you earned your income from illegal means doesn't mean you can avoid taxes on the income. In Louis E. Peyton (T.C. Memo. 2003-146) the Tax Court found the taxpayer had unreported income from drug sales. The Court held the income amount to be equal to that determined in the taxpayer's criminal trial. The Court also found that the income was subject to the self-employment tax.

The House Ways and Means Committee is working on a bill which creates health savings accounts ("HSAs") which provide for tax-favored savings for health care expenses. In general, an HSA is a tax-exempt trust or custodial account created exclusively for to pay for the qualified medical expenses and that is subject to rules similar to those applicable to individual retirement arrangements. Within limits, contributions to an HSA are deductible if made by an eligible individual and are excludable if made by the employer of an eligible individual. Distributions from an HSA for qualified medical expenses are not includible in income. Initially, contributions to the plan would be limited to $2,000 annually for a single individual and $4,000 for family coverage.

The House has passed, by a 264 to 163 vote, a bill that would make permanent the repeal of the estate tax that was enacted in the 2001 tax act. Passage in the Senate is less certain.

It appears that the House and Senate will attempt to reconcile the differences in their respective versions of the child tax credit bill that would make the credit refundable.

The IRS has mailed about 8.5 million copies of Publication 15-T, New Withholding Tables for 2003 reflecting the new, lower rates to small businesses. Employers should use these new tables as soon as they can work them into their payroll systems, but not later than July 1, 2003.

The IRS has issued a consumer alert, warning taxpayers about a new scam targeting potential recipients of the Advance Child Tax Credit. The Service has seen isolated instances of this new scheme. A taxpayer receives a telephone call from a person who promises to speed up the payment of the Advance Child Tax Credit checks. The catch is the taxpayer must agree to a $39.99 charge to a credit card. Clearly, no person or organization can speed up receipt of your check. If you're entitled to one, based on the information on file, you'll receive one in the mail. The IRS has a tax fraud hotline. Call 1-800-829-0433. For more information, see IRS News Release IR-2003-79.

One of the longest ongoing disputes with the IRS is the employee-independent contractor question. You may be able to avoid penalties for misclassifying a worker as an independent contractor if you can meet all the requirements of the Section 530 safe harbor. One of the requirements is that you must file all appropriate Forms 1099 for the workers. In Medical Emergency Care Associates, S.C. (120 TC--, No. 15) the taxpayer filed the required 1099s, but not on time. The IRS argued that the law requires timely filing. If the 1099s are late, the taxpayer has not complied with the safe harbor requirements. The Court held otherwise. It said there was no requirement that the 1099s be filed on time.

The IRS has announced a compliance initiative for nonresident aliens and foreign corporations that have not filed U.S. federal income tax returns and that may consequently be denied deductions and credits pursuant to Sec. 874(a) or 882(c)(2). Taxpayers that have requests for waivers pending with the IRS under Regs. 1.874-1(b)(2) or 1.882-4(a)(3)(ii) may also participate in this compliance initiative. This compliance initiative is intended to encourage nonresident aliens and foreign corporations to file income tax returns that were not filed in a timely manner in accordance with the regulations under Sec. 874(a) or 882(c)(2). The IRS will waive the filing deadlines set forth in Regs. 1.874-1(b)(1) and 1.882- 4(a)(3)(i) if a taxpayer files on or before September 15, 2003 all required U.S. federal income tax returns for every year for which a waiver is requested. In addition, a taxpayer must pay the reported income tax liability with each such return, must pay interest and penalties as determined by the IRS, and must cooperate with the IRS upon request in determining and satisfying its income tax liability for any taxable year for which a waiver is requested. To qualify for a waiver, a taxpayer must attach a statement to each late income tax return for which a waiver is requested agreeing to cooperate with the IRS upon request in determining and satisfying the taxpayer's income tax liability for that taxable year. The requirements of this compliance initiative may not be satisfied by filing protective returns. For more details see Notice 2003-38 (IRB 2003-27).

Changing ordinary income into capital gain can rarely be accomplished. In Charles Johns (T.C. Memo. 2003-140) the taxpayer tried to claim a winning lottery ticket was a capital asset and, thus, the amounts he received for the assignment of the ticket should constitute a capital gain. Neither the IRS nor the Tax Court agreed. The Court followed an earlier ruling (Davis) which held the payments received were ordinary income because they were received in exchange for a right to receive future income that would have been ordinary to the taxpayer.

The IRS has issued proposed regulations (REG-122917-02) relating to statutory options. These proposed regulations affect certain taxpayers who participate in the transfer of stock pursuant to the exercise of incentive stock options and the exercise of options granted pursuant to an employee stock purchase plan (statutory options). These proposed regulations provide guidance to assist these taxpayers in complying with the law in addition to clarifying rules regarding statutory options. This document also withdraws a previous notice of proposed rulemaking.

What's next on the tax agenda in Congress? The bills at the top of the list would permanently repeal the estate tax, expand health savings accounts, and provide taxpayer protection.

Be careful how you draft a contract, you'll probably be stuck with it. In Jerry L. Thomas and Freda Thomas (2003-1 USTC 50,460; U.S. Court of Appeals, 11th Circuit) the taxpayers sold their business in a stock transaction and signed a noncompete agreement. For several years the taxpayers reported the payments received on the noncompete agreement as ordinary income. They then filed amended returns reporting the income as a capital gain, claiming the agreement did not reflect the parties' true intent. The Court sided with the IRS, holding that a modification in the agreement did not create a quasi-new agreement allowing the taxpayers to change the nature of the income.

The IRS has released a draft version of Form 8836, Qualify Children Residency Status that taxpayers will be asked to complete before filing their return to precertify them. While not mandatory, taxpayers will be encouraged to complete the form and attach documentation to establish that the children claimed meet the residency requirement for the earned income credit. Taxpayers who fail to precertify will have to complete the same forms and provide documentation with their tax returns.

The IRS has issued temporary regulations (T.D. 9061) providing an automatic extension of time to file certain information returns and exempt organization returns. The temporary regulations remove the requirement for a signature and an explanation to obtain an automatic extension of time to file these returns. As of June 11, 2003, filers of information returns on Form 1099 (series), 1098 (series), 5498 (series), W-2 (series) W-2G, 1042-S, and 8027 can obtain an extension of time to file these information returns by submitting a signed paper Form 8809, Request for Extension of Time to File Information Returns. These temporary regulations allow filers and transmitters to request an automatic 30-day extension of time to file without having to sign Form 8809 and provide an explanation. An explanation and a signature are required if filers and transmitters need additional time to file after receiving the automatic 30-day extension. The extensions apply only to the filing with the government. The filer or transmitter is still required to provide statements to the recipients by the date specified in the Code or the regulations. The temporary regulations affect taxpayers who are required to file certain information returns and/or exempt organization returns and need an extension of time to file. The new rules will allow the IRS to develop an effective online version of the extension request. Filers and transmitters will benefit from the simplified extension procedure that will provide immediate approval. The IRS will benefit from the efficiencies inherent in such a system and will move closer to achieving electronic filing goals. Filers and transmitters are eligible for only one automatic extension of time to file.

The IRS has issued final regulations (T.D. 9059) relating to the allocation of basis adjustments among partnership assets under section 755. The regulations are necessary to implement section 1060, which applies the residual method to certain partnership transactions.

The IRS has reported that some small corporations have been reporting and paying alternative minimum tax (AMT) for which they are not liable. The AMT was repealed for qualifying small corporations for tax years beginning after December 31, 1997, but some of these businesses continue to compute and pay AMT on Form 1120, U.S. Corporation Income Tax Return.

The IRS may be using data mining methods to find high-income taxpayers that are underreporting their income. Of particular interest are those who receive K-1s from S corporations and partnerships. Of particular concern are "tiered entities", that is, entities that both receive a K-1 and issue them. Partnerships and trusts account for the bulk of the focus.

Worthlessness is often difficult to prove. In In re Terri L. Steffen (2003-1 USTC 50,454; U.S. Bankruptcy Court, Middle Dist. Fla., Tampa Div.) the taxpayer claimed that stock she held had no value. The Court noted that the company was in financial difficulty and eventually did declare bankruptcy, it was not clear at the time the taxpayer claimed worthlessness that the stock had no value. The Court also noted that the taxpayer must have considered that the stock was not worthless because they used the shares as collateral for a loan.

Awards for physical injury or sickness are generally not taxable income. Most other damage awards, including employment discrimination are taxable. In Johnny Paul Young (2003-1 USTC 50,456; U.S. Court of Appeals, 6th Circuit) the Court held the taxpayer was not entitled to a refund of taxes withheld by his former employer associated with a discrimination settlement.

Jobs and Growth Tax Relief Reconciliation Act of 2003--Part III

Capital Gains and Dividends

Reduction in Capital Gain Rates

The new law reduces the tax on long-term capital gains to 15% (from 20%) for taxpayers in the 25% and higher brackets and to 5% (from 10%) for taxpayers in the 10% and 15% ordinary income tax brackets. This should simplify tax preparation in future years because the 18% rate on property held 5 years or more (which wouldn't apply for a few years anyway) won't apply, nor will the 8% rate for some taxpayers who held property 5 years or more and are in the 10% and 15% brackets. However, for 2003 returns, computations will be more complicated because the old rates will apply to sales of assets and payments received on installment sales occurring before May 6, 2003 while the new rates will apply to sales on or after May 6, 2003.

Long-term capital gain rates on sales and installment payments received through May 5, 2003:

 8% for taxpayers in the 10% and 15% bracket on assets held more than 5 years
10% for taxpayers in the 10% and 15% bracket on assets held more than 1 year
20% for taxpayers in higher brackets on assets held more than 1 year
25% on qualified depreciation recapture
28% on collectibles

Long-term capital gain rates on sales and installment payments received on and after May 6, 2003:

 5% for taxpayers in the 10% and 15% bracket on assets held more than 1 year
15% for taxpayers in higher brackets on assets held more than 1 year
25% on qualified depreciation recapture
28% on collectibles

Tax Tip--Since the differential between ordinary income rates and long-term capital gain rates is even larger than before (maximum of 20 percentage points (35% less 15%) vs. 18.6 percentage points (38.6% less 20%)) it makes more sense than ever to try and hold and gain assets for more than a year. Of course, investment considerations should come first. But, if you're close to the magic 12-month threshold, you should consider holding on for a little longer. The closer you are, the larger the effective return for holding the extra time. The best approach is to compute how much of the gain you can lose before you'd be just as well off by selling at the current price.

Example--You've held your Madison Inc. stock for 11 months and have a $20,000 gain. How much can the price of the stock decline before you'd be just as well off to sell it today? The amount is different for each tax bracket. You can compute the factor to apply by dividing 1-long-term capital gain rate by 1-ordinary income tax rate. For example, if you're in the 35% bracket the factor would be (1-.15)/(1-.35) or 1.3077. Divide this factor into the $20,000 gain to get $15,294. Thus, the stock could drop by $4,706 ($20,000 - $15,294) before holding for the long term doesn't make sense. We computed the factors for the various tax rates and put them in a table below.

Factor to Compute Equivalent Return for Long-Term Holding Period

Tax Bracket        Factor

   10%             1.0556
   15%             1.1176
   25%             1.1333
   28%             1.1806
   33%             1.2687
   35%             1.3077

Tax Tip--The lower long-term rates mean that you should be less reluctant to sell out stocks you've held at a gain to rebalance your portfolio.

Tax Tip--Since the capital gain rates are now lower, if you've got unrealized long-term losses but no offsetting long-term gains, take the losses currently. Net losses of up to $3,000 per year can be used to offset ordinary income. Thus, if you take losses that aren't offset, you can save taxes at the higher, ordinary income, rates. Long-term losses that are used against long-term gains only save taxes at 15% (or 5%). Talk to your tax or financial advisor.

Small business stock. Individual investors who sell qualifying small business stock can exclude up to 50% of the gain, but the final gain is taxed at the same rate as collectibles, 28%, making the effective tax rate on the total gain 14%. Qualifying stock is stock issued after August 10, 1993 in a C corporation held for more than 5 years. At least 80% of the corporation's assets must be in an active trade or business. Under prior law, 42% of the excluded gain was a tax preference item for minimum tax purposes. Under the new law, only 7% of the 50% exclusion is a tax preference. The new rule applies to sales of small business stock on or after May 6, 2003.

This change will significantly reduce the alternative minimum tax liability for taxpayers selling qualifying small business stock. However, taxpayers selling qualifying stock might not want to take advantage of the 50% exclusion since the difference between the regular capital gain tax rate (15%) and the effective rate on qualifying stock (14%) is now only one percentage point.

Please see the section below for additional tax planning tips that are affected by both the capital gain and dividend rate cuts.

Dividend Rate Cut

The change here is simple. In an effort to reduce the potential double taxation of corporate dividends, qualifying dividends will now be taxed as a net capital gain and at the new rates--15% for taxpayers in the 25% and higher brackets and 5% for those in the 10% and 15% brackets. The reduced rates apply to dividends received from January 1, 2003 through December 31, 2008. For taxpayers in the 10% and 15% brackets, a 0% rate on dividends applies for the year 2008 only.

Note that, as opposed to the rate change for capital gains, the lower rates apply to dividends received during all of 2003, including dividends received before the date the law became effective.

Not all dividends qualify for the reduced rate. Only dividends from domestic corporations and qualifying foreign corporations. A qualifying foreign corporation is one whose stock is traded on an established U.S. securities market, incorporated in a U.S. possession, or if the corporation is incorporated in a country where certain treaty requirements are met.

The following dividends do not qualify for the new rates:

• Dividends paid by credit unions, mutual insurance companies, mutual savings banks, farmer's cooperatives, and tax-exempt cemetery companies.
  
• Dividends from any corporation exempt from federal income tax under Sec. 501 or 521.
  
• Dividends on employer securities owned by an employee stock ownership plan (ESOP).
  
• Dividends on stock owned for less than 60 days during the 120-day period before and after the ex-dividend date of the stock.
  
• Dividends where the taxpayer is obligated (whether pursuant to a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property.
  
• Where substitute payments are made in lieu of a dividend as in stock on loan in a short sale.

Some explanation is needed for several of the conditions above.

Minimum holding period. To prevent investors from buying the stock for the dividend and then selling, you must hold the stock for a minimum time period around the ex-dividend date. The reduced dividend rate only applies to stock held at least 60 days in the 120-day period beginning 60 days before the ex-dividend date. This is unlikely to affect most investors, since most dividend paying stocks tend to be less volatile and are often aren't traded. However, you could make a mistake and inadvertently sell the stock without meeting the holding period. Check the dividend dates before selling. Most traders won't care about the dividend; they're more interested in making money on stock price.

Example 1--You purchased 100 shares of Madison Inc. on June 1, 2003. The stock goes ex-dividend on June 25. You sell the shares on July 25, 2003. Since your haven't held the stock for 60 days in the 120-day period (the 120-day period started April 25 and ends August 25), the dividend is taxed at ordinary income rates.

Example 2--Assume the facts are the same as in the example above, except you purchased the stock on April 1, 2003. You've held the stock for more than 60 days in the 120-day period. In fact, you could have sold the stock June 26 and qualified for the preferential rates.

Example 3--Assume you bought the stock on June 24. You'd have to hold the stock till August 25 to comply with the 60-day rule.

Should you make the election to pay tax on the dividends at ordinary income rates? Since the interest expense that's not deductible in one year can be carried forward, there's probably no reason to make the election if you'll have additional qualifying investment income in succeeding years. If not, you've got to work through the numbers. Making the election can be beneficial in some circumstances.

Preferred stock. Dividends on true preferred stock will qualify for the lower rates. However, corporations have issued a type of hybrid preferred stock that is claimed to be debt by the issuer so that the interest payments are deductible to them. Taxes on these payments will be at the ordinary income tax rates.

Money market, real estate investment trusts, and mutual funds. The IRS has always said that amounts received from money market mutual funds are to be reported as dividends. Since the amounts actually represent interest, they won't qualify.

Generally, the income from real estate investment trusts (REITs) isn't taxed at the trust level. Thus, most dividends received from REITs won't qualify for the special dividend rates. There can be exceptions to this general rule. That is, some REIT income can be taxed. If so, the amount passed through to the shareholder will qualify for the special rate.

Most dividends passed through from mutual funds that invest in equity securities will qualify for the special rate. However, even stock funds could generate some interest income. That will not qualify for the special rate.

You'll have to check your 1099s for 2003 more carefully than ever. Income distributed by mutual funds will be reported in a number of different categories. Even the IRS isn't sure at this time how the income will be reported.

Tax Tip--For many funds, the reduced tax on dividends could be illusionary. Much of the dividend income generated by the fund could be offset by management fees before being passed through to the shareholders. Income funds would be the exception. The dividend yield should be high enough to more than offset the management and other fees.

Dividends on stock on which substantially similar positions are held. If you're required to make related payments on substantially similar property, the dividends received will not qualify for the special rate. While the most common situation where such related payments will be required is in a short sale, there are other types of transactions which could give rise to these payments.

Example--You own 1000 shares of Madison Inc. You've also sold short 800 shares of Madison Inc. On June 19 Madison pays a dividend of $2 a share, for a total of $2,000. You're required to make a payment of $1,600 ($2 X 800 shares) on shares sold short. Only $400 ($2,000 - $1,600) of the dividend qualifies for the reduced rate.

Tax Planning Under the New Rules

The lower rates on capital gains and dividends will dictate some important changes in tax strategy. Here are some thoughts.

S vs. C corporation. Should you be doing business as a C or S corporation? While the rules have changed, the outcome may still be the same. Dividends from C (regular) corporations will now be taxed at only 15%. That should be an advantage to C corporations. And the new 15% rate on personal holding company income and accumulated earnings reduces the penalty tax trap of C corporations. (See below.)

On the other hand, the individual tax rates on ordinary income are now lower, while the corporate rates have not changed. And, unless you take the earnings out of the C corporation as salary, you'll be subject to the double tax, either when taking a dividend or if you sell the assets and liquidate the corporation. Personal service corporations continue to be taxed at a flat 35%. The new law doesn't change the balance of the analysis for these special entities. In most cases they're better off doing business as an S corporation.

There's probably little or no reason to switch from an S to a C corporation. But the incentive to switch from a C to an S corporation may also be reduced. After doing a numbers analysis, be sure to examine other, intangible, factors.

Dividends from closely held corporations. Taking dividends from closely held C corporations is now less costly. Instead of a potential tax at 38.9%, the maximum rate is 15%. But, the dividends are still not deductible by the corporation. You may be able to find an optimal mix of salary and dividends that will minimize the combined taxes of the C corporation and the individual shareholders.

Example--You're the sole shareholder of Madison Inc. For 2003 the corporation has income after your salary, of $40,000. Your taxable income is $200,000. Taking a bonus of $10,000 would save the corporation only $1500 (the corporation is in the 15% bracket) and result in $3,300 of taxes on your individual return (33% rate). The net cost would be $1,800. On the other hand, if you take a $10,000 dividend there would be no tax saving to the corporation but you'd pay tax of only $1,500 on your individual return. The net tax saving of the dividend approach would be $300.

One thing is sure. You definitely don't want to generate dividend or capital gain income in the corporation. That is, if you want to invest in stocks or assets likely to appreciate and produce dividend or capital gain income, it's best to hold the asset in your own name. That's because capital gain income is taxed at ordinary income (or no more than 35%) when generated in a corporation and dividends, while they qualify for the 70% dividend exclusion, are still subject to the double tax.

Keep in mind that not every distribution from a corporation is a dividend. Dividends are only distributions paid out of earnings and profits. The definition of earnings and profits is complicated, but it's similar to retained earnings.

Dividends instead of salary. Some articles have suggested that paying a dividend in lieu of a salary is advantageous. That's generally not true. Moreover, the IRS can recharacterize the payments as salary instead of a dividend, just as they do in the case of S corporation distributions. You should take a reasonable salary.

Investing for the dividend. The reduced dividend and long-term capital gain rates will almost surely alter your investment strategy. But there's no reason to completely eliminate bonds or other fixed income investments to gain the lower rate on dividends. In the 35% bracket you'll need to get only a 3.82% dividend yield to equal a 5% interest rate. But in the 15% bracket you'll need a 4.47% dividend yield to do the same.

Example--How do you compute the equivalent dividend yield needed to equal a fully taxable interest? We've included two conversion tables, below. The first contains factors that allow you to find an equivalent dividend yield given a fully taxable interest rate. For example, you're in the 33% tax bracket. You can get 6% on a corporate bond. What would the dividend yield have to be on a stock that qualifies for the 15% dividend rate? The factor for the 33% bracket is 0.7882. Multiply .7882 by 6% and the dividend yield needed is 4.7292%. To compute the needed interest rate given a dividend yield, use the second table. At 33% the factor is 1.2687. If the dividend is 4%, you'll need to get 5.0748% for an interest return.

To Find an Equivalent Dividend Yield Given an Interest Rate

Tax Rate       Multiply Interest Rate By:

  10%                    0.9474
  15%                    0.8947
  25%                    0.8824
  28%                    0.8471
  33%                    0.7882
  35%                    0.7647

To Find an Equivalent Interest Rate Given a Dividend Yield

Tax Rate       Multiply Dividend Yield By:

  10%                    1.0555
  15%                    1.1177
  25%                    1.1333
  28%                    1.1805
  33%                    1.2687
  35%                    1.3077

Annuities, qualified plans, etc. Annuities and qualified pension plans (including deductible and nondeductible IRAs) are now relatively less attractive since distributions, whether from interest, dividends, or capital gains, will all be taxed at ordinary income rates. But, again, that doesn't mean they are no longer worthwhile vehicles. Annuities have other features which can more than outweigh the ordinary income tax consequences for some investors. And you should still generally try to maximize your contributions to qualified plans including 401(k)s. Roth IRAs still make considerable sense. But you might want to shift your investment strategy. Unless you're very young, you probably want a portion of your portfolio in fixed income vehicles. Use your IRA or qualified plan to invest in them first. Hold stocks that generate dividends and capital gains in your own name. And, as before, you've got to consider your current tax bracket and the bracket you'll be in at retirement. If you'll be in a much lower bracket, deferring income makes sense.

Qualified college savings plans (529 plans) also make sense because you can avoid all income if the funds are used for education purposes. But consider that your child may be paying tax at only 5% on dividends and capital gains. That could outweigh the fees and reduced flexibility in a 529 plan. You might want to hedge your bets. Put a portion of your college savings in a 529 plan; put some in custodial accounts.

Municipal bonds. Tax-exempt bonds now seem to be less attractive relative to dividend paying stocks. But there are many factors to consider. Currently, many municipal bonds pay a relatively attractive return and all the interest income is exempt. It may also be exempt on your state return. Many issues carry a low risk, but some are more risky than equity investments. One advantage of municipal bonds is that the interest generally does not increase your AGI (adjusted gross income). That can be important if you're near one of the AGI thresholds. For example, the child tax credit, education credits, etc. are phased out above certain income levels. If you're consistently near the threshold, keeping your AGI low by using tax-exempt bonds might result in significant tax savings.

Charitable contributions of appreciated property. While it generally still makes sense to gift appreciated property such as stock to a charity rather than selling it, paying tax on the gain and then contributing the cash, there can be situations selling is a smarter move. Talk to your tax or financial professional and do a thorough analysis.

Like-kind exchange. Like-kind exchanges can defer taxes on asset sales. But you also lose the fresh start basis and can be difficult to manage. You should give new consideration to paying tax on the gain, rather than jump for a like-kind exchange. Of course, there are many factors to consider, with the depreciation recapture rules an important one.

Restricted stock. Restricted stock in the company can be a vehicle for rewarding valued employees. The rules are complex, but the lower capital gain rates make the option more attractive than before. By making a special election, the gain can be taxed at capital gain rather than ordinary income rates.

Corporate Tax Changes

Collapsible corporation rules. The new law repeals the collapsible corporation rules (Sec. 341). While few corporations have been caught in this trap in recent years, the possibility always existed that what might have been a capital gain would be treated as ordinary income. The repeal of this provision expires at the end of 2008 unless extended.

Personal holding company tax rate. If 60% or more of a C corporation's income is personal holding company income (dividends, interest, capital gains, etc.) and certain other rules apply, the corporation can be subject to a penalty tax of 35%. Under the new law, that tax rate is reduced to 15% through 2008.

Accumulated earnings tax. C corporations that accumulate earnings and profits (similar to retained earnings) in excess of the needs of the business (plus $250,000 for most corporations; $150,000 for personal service corporations) could be subject to a penalty tax at 38.6% under prior law. While not often assessed, the impact on the corporation can be devastating. The new law reduces the tax rate to 15% through 2008.

While the change is significant, the tax is not gone entirely. And unfortunately, it's a tax on top of a tax. It's not instead of the regular tax on corporations, it's in addition to the regular tax. While the effect is not as horrendous as under the prior law, the tax can still cause financial havoc on a business unprepared to defend itself or pay the amount.

Corporate estimated tax payment. The new law defers the corporate estimated tax payment that would be due on September 15, 2003 to October 1, 2003. This is a one-time change. It's not the first time Congress has used this approach to move tax payments from one fiscal year to another.

In Brief:

Previously Reported In Daily Update

Contract doesn't determine worker status . . . Most businesses would rather have independent contractors than employees. There's less paperwork and cost. But the IRS will determine whether a worker is an employee or independent contractor based on the facts and circumstances, not the wording of any contract you may have with the worker. In a recent letter ruling (LR 200323022) the IRS ruled that a worker who was part of a two-person team who submitted a low bid for the job (a park attendant) was an employee. The worker was required to provide his own trailer as living quarters at the park. The IRS looked at the control the employer had over the work. It examined the facts that fall into three general categories--behavioral controls, financial controls, and relationship of the parties. The more control, the more a worker looks like an employee. The IRS noted that behavioral controls are evidenced by facts which illustrate whether the employer has a right to direct or control how the worker performs the specific tasks for which he or she is hired. Facts which illustrate whether there is a right to control how a worker performs a task include the provision of training or instruction. Financial controls are evidenced by facts which illustrate whether the employer has a right to direct or control the financial aspects of the worker's activities. These factors include whether a worker has made a significant investment, has unreimbursed expenses, and makes services available to the relevant market; the method of payment; and the opportunity for profit or loss. The relationship of the parties is generally evidenced by the parties' agreements and actions with respect to each other, including facts which show not only how they perceive their own relationship but also how they represent their relationship to others. Facts which illustrate how the parties perceive their relationship include the intent of the parties as expressed in written contracts, the provision of or lack of employee benefits, the right of the parties to terminate the relationship, the permanency of the relationship, and whether the services performed are part of the employer's regular business activities. In this case the IRS found the employer provided training and instructions on the methods to be used in completing the work. It set specific hours for when the work was to be performed and required the worker's personal services (they could not subcontract the work). The employer required the worker to maintain a logbook of park activities and records necessary for the administration of the user fee program. The worker could not hire helpers. The worker did not have a significant investment in facilities, inventory or tools to perform the work. The services of the worker were not available to the general public and there was no opportunity for the worker to realize a profit or incur a loss beyond the normal loss of pay. A contract can help, but it won't override other factors.

Read the fine print . . . If you do business as a partnership, LLC, or corporation and you have partners or other shareholders, read the fine print in any loan agreement. There's a good chance that the withdrawal of a partner or shareholder from the business will accelerate the loan. That is, the outstanding balance may become due immediately. Chances are the bank or other lender will modify the agreement if you advise them in advance of the withdrawal.

Homeowner's insurance coverage gets trickier . . . For years homeowner's insurance was a loss leader for many companies. Heavy losses in many areas have changed that. Insurance companies are assessing their risks more carefully. What does that mean? Some companies are now denying coverage if you have certain breeds of dog that they consider risky. Some will charge extra for a pool or won't insure you at all if the pool has a diving board. Trampolines are also considered risky. Insurers generally can't revoke your coverage if your situation changes, but they can refuse to renew your policy. That could be almost as bad. Thinking of not disclosing the trampoline if asked? That could be a bad move. Should someone be injured on the trampoline, your carrier may deny liability if the contract specifically excludes coverage. Best advice? Read the policy carefully and answer any questions carefully.

Not covered by worker's compensation? . . . You may think that worker's compensation is too expensive. But the potential cost of not having the insurance can devastate a business. In the Rhode Island nightclub fire the club owners apparently did not have coverage. Rhode Island law allows the imposition of a $1,000 per day penalty. (The state is considering tougher legislation.) The owners reportedly saved only a few thousand dollars in premiums, but have now been hit with a $1 million penalty for operating for three years without coverage. While you may not ever face those types of penalties, but you could find yourself sued by an employee who could have collected for injuries sustained on the job.

Like-kind exchange complicates depreciation computations . . . A like-kind exchange can defer tax on any gain or depreciation recapture, but it can also complicate your depreciation computations. Your basis in the new asset consists of two pieces--your carryover basis in the old asset and your cost basis in the new asset. For example, you trade in a truck with an adjusted basis (cost less depreciation) of $9,000 for a new truck costing $20,000 by paying $11,000 cash along with the trade in of the old truck. The $9,000 basis continues to be depreciated as if nothing happened. You can't take the Section 179 expense option on that basis. The $11,000 is considered new basis, and treated just as if you purchased a new truck for that amount. That is, it qualifies as new property (for purposes of the 50% bonus depreciation) and for the Section 179 expense option, as well as for the current depreciation rules.

Determining your principal residence . . . You can exclude the first $500,000 of gain (married, filing joint) on the sale of your principal residence. But what if you've owned and lived in more than one residence at a time. For example, you have a regular and a vacation home. The question is usually easy to answer; most taxpayers spend at most a few months a year in their vacation home. Even if you spend a considerable amount of time in the vacation home, the answer is usually clear. The law says it's where you spend the majority of the year. Thus, if you spend 190 days during 2003 in your vacation home, that's your principal residence for the year. But what if you spend 365 days in your main house in 2003 and 175 days in your vacation home for the other 4 years in a 5-year period? You may still be able to qualify for the 2 out of 5-year rule. The law says there are other factors that may be considered, including:

• Your place of employment;
  
• The principal place of abode of the your family members;
  
• The address listed on the your federal and state tax returns, driver's license, automobile registration, and voter registration card;
  
• Your mailing address for bills and correspondence;
  
• The location of your banks; and
  
• The location of religious organizations and recreational clubs with which you're affiliated.

Remember, no one factor is likely to be controlling and the courts don't have to look at all the factors. The courts have considered other factors including where your doctors are located, where your children go to school, etc. By the way, these same factors are often used by states in determining residency for tax purposes. You can bolster your case for one property being your principal residence if you plan ahead.

Checking your broker's record . . . While it won't give you all the answers a trip to www.nasdr.com will allow you to check on a broker's complaint record. Click on "Check Broker/Advisor Info" under the heading "Broker/Adviser Information".

Determining your holding period . . . Now that long-term capital gains are taxed at an even lower rate than before (15% for taxpayers in the 25% or higher bracket; 5% for those in the 10% and 15% bracket), determining your holding period is more critical than ever. If you purchased the asset, you should know the one-year holding period begins on the day after your acquire the asset and ends on the day the asset is disposed of. Remember, you've got to hold the property more than 12 months to make the gain long term. There are a number of special rules. One involves inherited property. The long-term holding period is generally considered met, no matter when you sell the property. For example, Fred Flood died on May 14, 2003 leaving you all his Madison Inc. shares. You sell the stock on May 21, 2003. The sale qualifies for long-term capital gain treatment.

Borrow to invest? . . . Should you refinance your home, taking out equity to invest? It depends. If you're going to buy a rental property that has great appreciation potential, it may make sense. Likewise, taking out a home equity loan to solve a short-term cash flow problem in your business or to purchase a working asset with a quick return on your investment may be ok. However, taking out a home equity loan to invest in the stock or bond market generally doesn't make sense, even at current loan rates. You're exposing your most valuable asset, your home, to extra risk.

Taxpayer ID number on line . . . Businesses can get Employer Identification Numbers (EIN) online from the IRS web site. You can now complete an application form online and the IRS will issue an employer identification number (EIN) that can be used immediately. For more information go to www.irs.gov/newsroom/article/0,,id=110174,00.html. For the online application go to www.irs.gov/businesses/small/article/0,,id=102767,00.html.

Estimated tax payments due . . . Today is the due day for individuals who have pay estimated taxes. If you're computing your estimated payments on your annualized income for the year, you should take into account the lower tax rates on ordinary income, dividends and capital gains. You've got to work through the numbers to determine the reduction. There's no rule of thumb. If you based your first quarter estimated taxes on your liability for last year, you might want to consider the annualized income method. That's particularly true if you don't expect your income to be as high.