News On The Tax Front--The latest tax news.
Advance to Related Corporation is Capital Contribution--You own two corporations. One corporation advances money to the other. There can be substantial tax consequences. This is what happened to one taxpayer.
State Tax Credits--Almost every state offers tax credits for various activities such as investing in new equipment, hiring new employees, rehabilitating historic buildings, etc. The credits can be susbtantial and available for both businesses and individuals. Here's what's available in two states.
Cost Cutting--If your business is being pinched (or even if it isn't) here are a number of tips on cutting costs that shouldn't be painful or hurt employee morale.
In Brief:--Tax, business, and personal finance tips.
Previously Reported In Daily Update
The IRS has announced (IR-2000-67) that the reorganized IRS will begin operations on October 1. While the change will be transparent to many taxpayers, it should result in improved service. The new IRS will be organized around four divisions:
The statute of limitations on tax returns is generally 3 years. However, if you omit more than 25% of the gross income stated on the return, the statute is extended to 6 years. In CC&F Western Operations Limited Partnership, CC&F Investors, Inc. (T.C. Memo. 2000-286) the taxpayer admitted that it failed to report more than 25% of its income, but argued that it adequately disclosed that failure on the returns of the entities involved. The Court didn't agree. It noted that in order to uncover the omission the IRS would have had to analyze and compare a number of returns and that was not reasonable.
On a number of occasions we've said that you may be able to avoid the negligence penalty if you can show you relied on a professional. In Clarence T. Thompson and Anna R. Thompson (2000-2 USTC 50,698; U.S. Court of Appeals, 10th Circuit) the Appeals Court sided with the lower court in holding that the advisor (taxpayer's accountant in this case) did not have to be an expert in the industry or an investment advisor in order for the taxpayer to reasonably rely on his advice. The important point was that he was an expert in taxes. Note. Better to play it safe. If you're making an investment, get both financial and industry advice. You'll be on safer ground.
If you sell a warranty (e.g., you agree to cover the cost of repairs of a product) the amount you receive for the warranty is generally fully taxable immediately. You can't take a deduction for any of the potential repair costs until you actually incur them, that is, a customer makes a claim. That's what the Tax Court held in Chrysler Corporation, f.k.a. Chrysler Holding Corporation (T.C. Memo. 2000-283).
When is a charitable contribution of property completed? In Kenneth L. Musgrave and Etta D. Musgrave (T.C. Memo. 2000-285) the taxpayers sold real estate to a church for less than the fair market value of the property. The difference between the fair market value and the sales price is the amount of the charitable contribution. The question here was when was the contribution completed. The taxpayers entered into the contract deed in one year but under state law complete title to the property did not pass until a later year. The Court held that the church had equitable title in the earlier year, the year the contract was entered into.
If your adjusted gross income (AGI) exceeds a certain level, a portion (50% or 85%, depending on your AGI) of your social security benefits are taxable. Most taxpayers are fully aware of those rules. Worker's compensation is not normally taxable. However, some taxpayers who receive both worker's compensation and social security benefits will find their social security benefits reduced by the amount of their worker's compensation payments. That's what happened in John M. and Norma A. Mikalonis (T.C. Memo. 2000-281). The taxpayers did not report the worker's compensation offset as a "social security benefit" when computing their taxable income. The Court found that the law was unambiguous on the point. Because of the couple's AGI, they had to include 85% of the worker's compensation received as taxable income.
Anyone can offset gambling winnings with any gambling losses (keep your receipts). In William T. and Deborah S. Praytor (T.C. Memo. 2000-282) the Tax Court held that even though the taxpayer was a professional gambler, he was only allowed to deduct his losses and expenses associated with gambling up to the amount of his gambling winnings. The limitation applied to all his gambling losses, whether or not he incurred them in a trade or business.
The Service has announced the release of four new IRS Publications:
The IRS has created a special new web section for taxpayers seeking information about their rights when dealing with the Service. The webpage is called Taxpayer Rights Corner. The page includes topics ranging from basic taxpayer information to detailed steps on how to get help from the IRS. The areas highlighted include:
If you decide to go to court and the government asks for information during discovery you can't delay too long. That's what the taxpayers did in Joseph J. and Eileen H. Lipari (T.C. Memo. 2000-280), even after court orders requiring them comply with the IRS requests. The Court imposed a delay penalty on the taxpayers.
In MRCA Information Services (2000-2 USTC 50,683; U.S. District Court, Dist. Conn.) the IRS denied the corporation's proposal for an installment agreement to pay overdue payroll and employment taxes for several quarters. The Court found that the denial of the request for an installment agreement was not an abuse of IRS discretion since the taxpayer had defaulted on two such agreements in the past and could not make a lump sum agreement.
The IRS has issued final regulations for the exclusion from income for qualified lessee construction allowances provided by a lessor to a lessee for the purpose of constructing long-lived property to be used by the lessee pursuant to a short-term lease. The final regulations affect a lessor and a lessee paying and receiving, respectively, qualified lessee construction allowances that are depreciated by a lessor as nonresidential real property and excluded from the lessee's gross income. The final regulations provided guidance on the exclusion, the information required to be furnished by the lessor and the lessee, and the time and manner for providing that information to the IRS. For more details see T.D. 8901 in IRS Bulletin No. 38.
Before you go to court, make sure you're qualified to file the case. In PM Trust (T.C. Memo. 2000-272) the Tax Court held that the individual who filed the case was not qualified to do so since he was not a trustee of the irrevocable trust. The trust document did not define the title "managing director" which the individual listed as his position when he filed the petition.
In Dereco, Inc. (T.C. Memo. 2000-279) the Court found the guilty of fraud where no representative of the taxpayer appeared for the trial. The Court found, based on the facts deemed admitted, that the taxpayer underreported its income while deducting personal expenses of its president and made false statements to the IRS. The fact that the taxpayer did not show up for court was additional evidence that it attempted to conceal the facts.
The IRS per diem rates are based on amounts developed by the General Services Administration for government employees. The GSA is now making per diem rate changes based on the government's fiscal year, rather than on a calendar year basis. The GSA announced the new rates on September 1. The IRS has announced (Notice 2000-48) that business travelers will have a choice of using the new rates beginning October 1 or continuing to use the old rates for the remainder of 2000.
The IRS has adopted final regulations that permit qualified defined contribution plans to be amended to eliminate some alternative forms in which an account balance plan can be paid under certain circumstances, and permit certain transfers between defined contribution plans that were not permitted under prior regulations. For the complete explanation of the new regulations, see T.D. 8900 in IRS Bulletin No. 2000-38.
The House has passed (vote of 401-20) a package that
consists of the debt relief bill passed on September 18th and the
pension liberalization bill passed in July. The Senate has a
similar bill pending which is expected to come before the full
chamber next week. There's also bipartisan support in the
Senate. Both bills would:
The House has passed a debt relief bill that would allocate 90% of the fiscal 2001 surplus for debt relief. The remaining 10%, estimated at $28 billion, would be used for tax cuts and some spending initiatives. Tax cuts are expected to include a repeal of the 3% excise tax on telephone services, some pension and IRA breaks, health care tax changes and some small business cuts. The bill passed the House with a 381-3 vote, so it stands an excellent chance of making it to law.
This string of horse breeding losses might break a record. In Louis A. Filios, Estate of Emma L. Filios, Deceased (2000-2 USTC 50,670; U.S. Court of Appeals, 1st Circuit) the taxpayer had an unbroken run of 37 years of losses totaling some $6.65 million dollars. In the last few years the losses averaged about $600,000 per year. The Court disallowed the losses for the years at issue citing the fact that the taxpayers did not prepare a written business plan, conduct economic or business studies, never hired business advisers or consulted with experts on business issues, and didn't change business methods despite the losses.
The appeals court has overturned a Tax Court decision in Stanley M. Kurzet and Anne L. Kurzet (2000-2 USTC 50,671; U.S. Court of Appeals, 10th Circuit). The Tax Court (T.C. Memo. 1997-54) had held that the taxpayers could not deduct the expense of operating a Lear jet to travel to his timber and other business holdings. It found that the expense were not ordinary and necessary expenses of any of the businesses. The Court of Appeals held otherwise, finding the lower court should not have included depreciation in the computations and that the time savings were greater than the Tax Court's finding. It allowed the expenses.
There are special tax breaks for research and experimentation expenditures, but there are a number of special rules on what costs can qualify. In Tax and Accounting Software Corporation (2000-2 USTC 50,672; U.S. District Court, No. Dist. Okla.) the Court held that the taxpayer's expenditures incurred in developing accounting software did meet the so-called technology test and the process of experimentation test.
The House was unable to override the President's veto of the Marriage Penalty Relief Reconciliation Act. The bill would have provided approximately $1,400 annually for many married couples. With the failure of this bill, some experts believe Republicans will turn their attention to debt reduction. They have a plan that would use 90% of the budget surplus on debt reduction and the remaining 10% on cutting taxes.
Both presidential candidates have proposals that would provide tax relief to encourage higher education. The Bush plan would provide a tax exemption for all qualified tuition savings and prepaid plans while the Gore plan would allow a choice of a tax deduction for higher education costs or a 28% credit on the first $10,000 of tuition.
Advance to Related Corporation is Capital Contribution
The IRS has the power to recharacterize a transaction if it's not what it appears to be. That can be very costly. It can cause you to lose a deduction or have unexpected income, and can cause havoc with your tax and financial planning. In this case (J. Michael Shedd, et ux. et al., T.C. Memo. 2000-292) the taxpayer had a transaction recharacterized in two ways. First, an advance from one corporation to another was deemed to be a capital contribution instead of a loan. Second, the capital contribution was held to be a taxable dividend to the shareholder.
The facts were straightforward and not unusual. Mr. Shedd was the sole shareholder of two C corporations, J&J Management Group, Inc. (J&J) and TLC Management, Inc. (TLC). Both companies were engaged in the business of freight forwarding, J&J in Michigan and TLC in Ohio. TLC was incorporated with $500 paid-in capital, and no additional capital was contributed by the taxpayer. Over the course of 3 years J&J made advances in the total amount of $119,700 to TLC for operating expenses. The advances were evidenced by unsecured demand notes bearing 7% interest and signed by Mrs. Shedd as TLC's secretary. J&J did not require any personal guarantees from the Shedds on the advances to TLC. No repayment schedule was established, and J&J made no demand of TLC for payment of the principal or interest on the notes.
TLC was dissolved prior to April 1995. On its federal income tax return for that year, TLC reported $90,440 income due from the forgiveness of the debt described above, while J&J claimed the same amount as a bad debt deduction. The IRS disallowed the deduction.
Bad Debt
The court first looked at the bad debt issue. If the advance was true debt, business debts that become worthless within a tax year are deductible as ordinary losses. However, if the advance is really a contribution to capital, only a capital loss for worthless stock can be claimed. Whether the advance was a capital contribution or a loan depends on whether there is an intention to create an unconditional obligation to repay the advance. A taxpayer must show that an advance is a loan rather than a capital contribution.
In order to claim an ordinary loss, you must show that:
In seeking to determine whether an advance is a true debt or a capital contribution, the courts examine a number of factors. No one factor is likely to be determinative and the court doesn't have to give equal weight to each of the factors. The court tries to analyze the investment in terms of its economic reality and answer the question of whether the advance really represents risk capital (equity) or a strict debtor-creditor relationship.
The Court considered 11 factors here. Before reviewing them, we'll note that there was a formal, interest bearing note, signed by the secretary of the debtor (TLC). That's much more than many small businesses do in documenting such transactions. Here's what the Court noted in reviewing the factors.
Name given instruments evidencing indebtedness. The issuance of a note may be indicative of bona fide debt. The existence of a note, however, is not in and of itself conclusive. An unsecured note, on which no payments are made weighs toward equity capital. In this case the notes were signed, but not until the end of the fiscal year in which the funds were advanced. The notes were executed in amounts that were less than the amounts that were advanced. And the evidence showed no payments were ever made on the unsecured advances. The Court noted that when a transaction involves a closely held corporation, the forms and labels assigned to a transaction may mean little due to the parties' ability to mold the transaction to their will. Thus, the Court held that the notes had only a limited probative value in the Court's evaluation.
Presence or absence of fixed maturity date and schedule of payments. While the taxpayer's argued that the demand notes weighed in their favor, the Court did not agree. The IRS can always argue that the creditor, being related, is unlikely to demand repayment on a demand note if that would prove to be a problem to the debtor. Most tax advisors would suggest that there be a repayment schedule or fixed due date for the note. Of course, that can backfire if you can't make the payments on time. Best approach? Construct a payment schedule that you can meet.
Source of repayments. If the expectation of repayment depends solely on the success of the borrower's business, the transaction has the appearance of a capital contribution. An expectation of repayment solely from corporate earnings is not indicative of a bona fide debt. (With a true debt the lender might seize assets to get paid.) Here the taxpayers did not show that the loan repayments would come from a source other than TLC's business receipts.
Right to enforce payments. A definite obligation to repay principal and interest favors the existence of debt. Repayment that is within the discretion of the parties and conditioned upon the occurrence of certain events is more like equity. Even where there is a basic right to enforce payment, failure to take customary steps to ensure payment, such as securing the advance or establishing a sinking fund, may indicate an equity rather than a debt relationship.
Participation in management as a result of the advances. Normally, acquisition of management responsibilities by a party advancing funds is likely to be evidence of an equity relationship. In this case, however, Mr. Shedd was already the managing shareholder of both J&J and TLC. That's also likely to be true in most similar situations. However, you could trap yourself if, a management position is granted to a creditor as a condition of advancing funds.
Status of the advances in relation to regular corporate creditors. Subordination of advances to claims of other creditors indicates that the advances are capital contributions and not loans. Here the Court found insufficient evidence to make a decision. This is usually one place where the factor almost always weighs against you. No outside lender will let you put your loan ahead of theirs.
Ratio of debt to capital of the corporation. Thin or inadequate capitalization (equity capital) of the borrower is strong evidence that the advances are capital contributions rather than loans. In this case the debt-to-equity ratio was about 200 to 1. That's clearly excessive and indicates the advances were really equity capital.
Where's the dividing line? There is no hard and fast rule. It depends on a number of factors including the type of business. A 10-to-1 (debt-to-equity) ratio would not be excessive for a real estate rental business, but a court might consider a lesser ratio excessive for a small service business.
Ability of the corporation to obtain credit from outside sources. If a party receiving an advance can borrow funds from another lender in an arm's-length transaction on similar terms, the advance should appear to be debt. This factor usually goes against small businesses. Most banks won't lend funds to a small business with little equity unless the owners provide personal guarantees or collateral for the loans.
In this case, the factor might actually have been positive for the taxpayer. The chief financial officer of a freight forwarding association of which J&J was a member, testified that the association would have made the loans to TLC, up to the $90,000 that was advanced. He spoke of the industry norm of thin capitalization and of the practice of advancing funds to companies losing money for a certain period of time. He also indicated that personal guarantees were not required on the notes.
Unfortunately, J&J did not advance funds to TLC in the exact manner the association would have. The association would have withheld 10% of the commissions generated that was due to the debtor until the loan was fully repaid. That was not the case in the loan between J&J and TLC. In addition, any loan from the association would have a termination date. That was not present in the loan between J&J and TLC.
Use to which the advances are put. The use of the advances to meet the daily operating needs of the corporation, rather than to purchase capital assets, is indicative of bona fide indebtedness. In this case the advanced funds were used to pay the operating expenses of TLC. Thus, this factor helped the taxpayer.
Failure of debtor to repay. The absence of payments of principal or interest is a strong indication that the advances were capital contributions rather than loans. In this case TLC never made a payment over the 4-year period when it received funds from J&J, nor did J&J make any demand for payment. Accordingly, it appears that J&J never intended to compel repayment of the advances.
The lack of repayment is often an important factor in the court's decision. That's why a demand note on which no payments are made is often viewed negatively. On the other hand, missed payments where there is a schedule of repayments, isn't good either. The repayment schedule should be one that can be met. However, you can't use a very long repayment schedule. A 20-year schedule for a loan for the operating needs of the business can be a negative since it's unlikely a bank or other commercial lender would provide funds on such terms.
While interest repayments are essential, principal repayments are also very important.
Risk involved in making advances. The absence of security for the advances indicates that the advances were capital contributions and not bona fide loans.
Commercial lenders want collateral or personal guarantees for risky loans. And many small business loans are risky. While it might seem foolish, if the corporation can possibly provide collateral for the loan, it should do so. The same is true for personal guarantees by the shareholders.
There are several other factors, not discussed by the court which could be used in determining the status of an advance. They include:
Recording on books. If you use a CPA or professional accountant, he'll record the advance properly on the books. It's not unusual for some business owners to get sloppy and either record the advance incorrectly, or fail to record it at all. That could be a big negative.
Capacity to repay. This often isn't a separate factor, but part of one or more of the other factors listed above. But clearly, if the business is unlikely to be able to repay the advance, it can't be debt but equity capital.
Convertible feature. If the debt is convertible into stock of the corporation, that makes it appear more like equity capital. Avoid that in a loan between related entities or where a shareholder loans money to the corporation. Warrants, options, etc. may also have negative implications.
Relationship between stockholdings and advances. If each shareholder is making "loans" in the same proportion as his or her stockholdings, the court may view the advances as additional equity capital.
The Court decided that the advances were contributions to capital and not loans. Since most of the factors clearly indicated the advances were capital contributions, there was very little doubt. Most small businesses will have trouble with loans to the corporation unless they're careful to deal with the factors discussed above. While you don't have to have every one of them on your side, you should try to have a preponderance of them in your favor. Then you might stand a chance. You can easily deal with some of the factors (written promise to pay, interest rate, repayments of principal and interest, commercially acceptable terms, proper recording of the advances on the company's books, personal guarantees, etc.). Doing so may be enough to tip the scales in your favor.
Constructive Dividend to Shareholder
There was a second, related, issue in this case. The IRS argued that, since the advance from J&J to TLC wasn't a loan but a capital contribution, the transaction wasn't really between J&J and TLC. Instead it was a distribution from J&J to the sole shareholder followed by a capital contribution from the shareholder to TLC. The would mean the distribution from J&J would be taxable dividend to the shareholder, even though no formal dividend declaration was made. If that's the case, the taxpayer has taxable income equal to the amount of the distribution (over $90,000 in this case).
The Court noted that two tests are normally employed to decide whether a transfer between related corporations constitutes a constructive dividend. Once is an objective distribution test and the other a subjective test of primary purposes, both of which must be satisfied.
First, there must be a distribution from the transferring corporation's earnings and profits (the tax jargon equivalent of retained earnings). This test requires property to leave the control of the transferor corporation (J&J here) in a way that allows a common shareholder to directly or indirectly control the property through some other instrumentality. Where property is transferred between related corporations, a common shareholder does not personally receive the property. Therefore, a distribution is considered to occur when a transferee corporation (TLC here) attains an increase in assets or control at the expense of the transferor corporation. When J&J advanced the funds to TLC, Mr. Shedd, as president and sole shareholder of TLC, then had indirect control over those funds. Thus, the transfer met the objective test.
The second test is designed to differentiate between normal business transactions of related corporations and those designed primarily to benefit a common shareholder. The primary or dominant motivation for a distribution must be examined. The taxpayer must show a legitimate corporate or business justification which is the primary reason for the advance and which is sufficient to overcome the conclusion that Mr. Shedd, as the shareholder, primarily benefited from the advance of funds. A legitimate corporate justification is demonstrated by showing that the distribution would be in the best interest of the transferring corporation (J&J). If justifiable business reasons exist that account for the transfer, that would be enough to override any incidental or derivative benefit to a common shareholder. However, where a corporation's distribution serves no legitimate corporate purpose, it must be treated as a constructive dividend to the shareholder.
The taxpayer testified that J&J lent the money to TLC in order to create a business with which it could share costs of forwarding freight. While this would be a valid business purpose, the taxpayers presented no documentary or corroborating evidence of any savings over the 4-year period funds were advanced. The taxpayers presented no evidence or testimony explaining the business purpose of the advances. They did not show that they were acting in J&J's business interests when the funds were advanced to TLC. Instead, it appeared that the Mr. Shedd was acting in his own best interests as sole shareholder of TLC when he injected additional capital into TLC, an inadequately capitalized entity.
This recharacterization of an advance between two entities into a dividend to the shareholders followed by a capital contribution to the other corporation could affect both regular and S corporations.
While the case involved advances between two related corporations, the IRS often recharacterizes advances by a shareholder to his or her corporation using the same approach. The results may be only slightly different. Repayments on the advance, recharacterized as equity capital could result in a taxable dividend.
You may have a number of options, depending on your particular situation. In many cases you may be able to show a bona fide loan exists. In some situations you may want to take money out of one corporation (through either a dividend or distribution that may not be taxable or a bona fide loan), and make a capital contribution to the other corporation. A capital contribution that meets the requirements of Sec. 1244 will result in an ordinary loss (up to $100,000) should the stock in the corporation prove worthless. Talk to your tax adviser. He may have other suggestions based on your situation.
Congress repealed the investment tax credit some 14 years ago. While this credit for equipment purchases may be long gone for federal purposes, a number of states still allow taxpayers a similar credit toward their state income taxes. Most states with an income tax offer more than one credit against taxes. Credits are usually provided to encourage a socially benefiting activity (e.g., a credit for the purchase of electric cars to reduce air pollution), to get businesses to relocate to the state, to get businesses within the state to relocate to economically depressed areas in the state, etc. Not infrequently, the credits are a pet project of one or more lawmakers. Whatever the reason, the benefits can be significant. Don't forget, a credit creates a dollar-for-dollar reduction in your taxes. That's much more beneficial than a deduction which will only provide a small benefit, depending on the state tax rate.
Example--Madison has a plant in state A that allows a deduction for research expenditures. The state tax rate is 10% on taxable income. A $100 deduction will provide Madison with a $10 cash saving.
Example--Madison has another plant in state B that allows both a deduction and a credit for research expenditures. The state tax rate is the same. The credit is equal to 20% of the expenditures. Here Madison gets the same deduction as in state A, but, in addition, it can deduct another $20 (20% of $100) from it's taxes for a total cash saving of $30.
It's not unusual for the deduction to be disallowed if you can take a credit for the expenditure.
Example--Madison has a plant in state C that allows either a deduction or a credit for research expenditures. If Madison takes the deduction, it'll have a cash saving of $10. If it forgoes the deduction, and takes the credit, it'll have a cash saving of $20.
If you have the option to choose one or the other, taking the credit is clearly preferable.
The nature and amount of the credits vary widely from state to state and, while there are generally more credits available for businesses, there are a number of credits available for individuals. Unfortunately, the credits are often not as publicized and, because they often apply to a limited number of taxpayers, it's easy to overlook them. Even professionals sometimes miss them.
We've made a partial list of the credits available in two states, New York and Massachusetts. Some of the credits are representative of what's available in other states (e.g., the investment credit). Others are unique to social, political, or other issues in those states.
In New York the following credits are available:
The list of credits in Massachusetts is much shorter. They include:
The credits can come with strings attached. You may have to "recapture" part or all of the credit if you sell or otherwise dispose of the equipment before the end of a certain time period, if you move the business, or a significant portion of it, out of the state before the end of a specified period.
Example--You're entitled to a credit on equipment equal to 10% of the purchase price. You purchase a $25,000 machine and take a $2,500 credit. To keep the full credit you must hold the equipment for 5 years. You must recapture 20% of the credit for each year under that. You sell the machine at the end of 3 years and have to recapture 40% of the credit (2 years times 20% per year), or $1,000.
Even if you have to recapture some of the credit, you'll still have benefited from the up-front cash and a portion of the credit.
Note. In some cases you have to reduce your basis in the asset or reduce your deduction by the amount of the credit taken. For example, on a $25,000 machine you can take a $2,500 credit. Your basis in the asset for depreciation may be reduced to $22,500. Similarly, if you can take a 20% credit for wages paid, you may have to reduce the amount of the wages that are deductible. Check the rules in your state.
You should look for credits or other special tax breaks if:
Discuss your situation with your tax advisor.
Before laying off employees, canceling the annual Christmas party, etc. look for more sensible ways to reduce costs. Virtually every business has areas where costs can be reduced with little or no pain.
If you worked at a large corporation (and even many smaller entities) you know what happens when profits or cash flow are under pressure. Management cuts out the free coffee, cancels all parties, and freezes salaries of all employees--under a certain level. While rank and file employees suffer, executive salaries are boosted, the company continues to order BMWs for company cars and the company jet gets a new paint job. As a result employee morale takes a dive.
There are better ways to handle the situation. The first is to make across the board cuts. That doesn't necessarily mean the cuts have to be equal in percentage terms, but there has to be some meaningful and visible cuts at the top. The second approach is to look for ways to reduce costs that don't cause undo pain to rank and file employees.
There are a number of measures you can take to reduce costs without inflicting pain. In fact, most of the steps mentioned below should be considered even if you're not in financial straits. Here are some thoughts:
Previously Reported In Daily Update
Constructive receipt . . . Even if you use the cash method of accounting you can't delay reporting income if you're in constructive receipt. Basically, if you could get the money, even though you didn't try, the income belongs to you. Such a situation only poses a problem at the end of the year. In recent Field Service Advice the taxpayer was a writer who had his material distributed by a publishing company. The company sent monthly statements to the taxpayer showing the revenues received, but did not make routine payments to him. Instead, the taxpayer would make periodic cash draws whenever he chose. The company placed no restrictions on the timing or amount of the draws. The taxpayer allowed the amounts to accumulate in the account and reported as income only the amounts he drew down. The IRS held that the taxpayer was in constructive receipt and had to report the amounts in the year he was able to draw. It noted the amounts were under the taxpayer's control and there were no substantial restrictions on withdrawals. In addition, the IRS found that the deferral of the income was a method of accounting and by filing two consecutive tax returns failing to recognize the improperly deferred income, the taxpayer adopted this practice as a method of accounting. That meant changing to the proper method was an involuntary change and the taxpayer had to report all the adjustment in one year.
Refinancing penalties deductible as interest . . . The INDOPCO, Inc. case won by the IRS that required the taxpayer to capitalize certain costs has encouraged the Service to require taxpayers to capitalize more expenses than before. However, in recently released IRS Field Service Advice the IRS held that prepayment penalties a corporation paid when it refinanced existing debt were deductible as interest and did not have to be capitalized. While Field Service Advice can't be cited as precedent, it can reflect IRS thinking on an issue. In this case the Service cited a number of prior revenue rulings.
Avoiding billing arguments . . . Before fax machines and e- mail, many companies accepted verbal orders over the phone. You can avoid disputes by requiring customers to send a purchase order. That can be done by fax or, if the customer is entering the PO in their computer, they can convert it to an Acrobat file that can be e-mailed. And a hard copy can reduce mistakes considerably. For quotes, give customers a formal quote that includes your terms (e.g., net 30; 15% restocking fee; etc.); that can also reduce disputes. A side benefit is that you decrease the opportunity for employee fraud.
Callable CDs . . . Once an oddity, more and more banks are issuing them. They generally pay a higher rate than similar CDs of the same maturity, but the bank can call or redeem them at any time, or anytime after a specified date. The bank is hoping to get customers to jump at the higher rate while reducing its risk by having the ability to call them should rates drop. You get the benefit of a current high rate, but run the risk of losing it and having to reinvest the funds should the CD be called. Are they a good deal? The larger the spread between a regular CD and a callable one, the more attractive they become. Unless an increase in rates is almost a sure thing (and that's probably not true currently), you don't want to risk getting called for a small increase. Consider your personal situation. Would having to reinvest the funds elsewhere be so bad? Of course, if you believe rates will soon decline, investing in a callable CD doesn't make sense.
Who can claim the education credits? . . . Only one person in any one year can claim the higher education credit for a student's expenses. If you are paying higher education costs for your dependent child, either you or your dependent child, but not both of you, can claim a credit in a particular year. If you claim an exemption for your child on your tax return, only you can claim a credit. If you do not claim an exemption for your child on your return, only your child can claim the credit.
Capital gains rate not always 20% . . . We always say the tax rate on long-term capital gains is 20%. Actually, the effective rate can be substantially higher. Why? While the tax rate on such gains is no more than 20%, capital gains will increase your adjusted gross income. And that will affect a number tax benefits. For example, assume you're married and your adjusted gross income before a capital gain is $70,000. You claim the Hope credit of $1,500 for your son and the lifetime learning credit of $1,000 for your daughter. Now assume you sell some stock and report a $30,000 capital gain. Because the Hope and lifetime learning credits are phased out with income above $80,000, you lose $2,500 in credits. The tax on that extra $30,000 of income is real 20% of $30,000 plus $2,500, for a total of $8,500 or 28.33%. At higher levels of AGI, you'll also lose some of your itemized deductions because of the phaseout. If you have rental properties, you'll lose the $25,000 exemption for passive losses. You may also find yourself subject to the alternative minimum tax because of the loss of the $40,000 exemption and the fact that the flat tax rate of the alternative minimum tax is greater than graduated rates that apply to your income. There's no easy way around the problem. In some cases taking all the gain upfront makes sense; in other situations, spreading the gain using an installment sale will reduce the tax bite. Sometimes using an installment sale to force the gain into the following year makes is the smartest move. For example, if you'll no longer be entitled to the education credits. Use a computer program to work through the numbers or check with your tax adviser.
Write the specs . . . If you're a vendor bidding on a contract where the purchaser isn't familiar with the technical issues, you may be able to help him or her write the specs for the job or item. That can give you a big leg up when later bidding the project. On the other hand, if you're the purchaser, you should be wary of a supplier or contractor who helps you with the specs. He could be designing the purchase order so that only he can supply the item or do the work. Or, he may be specing the job to maximize his profit. For example, requiring unnecessary items that result will improve his profit margin. If the supplier is helping you, consider getting a second opinion on what's required.
Contingent selling price deals . . . It's not unusual for a business owner to sell out with the price composed of two pieces- -a fixed dollar and a contingent amount. For example, you sell a portion of your business for $500,000 plus 5% of sales for the five years following the date of sale. A contingent selling price can make sense if the business has great potential, but current sales are held back by one or more factors. You could end up with much more for the business. There can be advantages for the buyer too. Should sales fail to materialize, he's out less money. But there are pitfalls in such a deal. The biggest is that there will be an argument over whether or not the milestones have been met. For example, the contract reads "5% of sales", but is that just sales of the store you're selling, web sales where you hadn't even considered the internet at the time of sale, etc. And do you mean gross sales, or net after returns and allowances? And what if the buyer lets his new acquisition languish by not advertising, etc. until the contingency period expires? This is where you need an experienced lawyer and accountant. You can reduce problems by keeping the definitions and contingency simple. For example, base the payout on sales, not earnings. Defining earnings is much more difficult and there's more room for the buyer to manipulate the numbers in his favor. Another point. Small contingency deals probably don't make sense. The legal, accounting and similar costs may outweigh the benefits.
Unit trusts . . . Most mutual funds are actively managed. That is, if the fund manager sees an attractive stock, he buys it. Conversely, if he thinks a stock will underperform the market, he sells it. (Index funds are not actively managed. The fund purchases stocks that are added to the index on which they're based (e.g., the S&P 500) and sells stocks that are dropped from the index.) A unit trust is different. The trust purchases a number of stocks at the beginning of its life cycle and never adds to, nor sells from, the basket. The trust automatically liquidates at the end of a certain time period, typically one year. You can roll over your investment into a new trust. Often the managers assemble a new list of stocks for a new cycle. In the case of a fixed income trust, the bonds purchased gradually mature over time and the fund returns some of the principal to investors each year. Does a unit trust make sense? Some have done well, and you can't argue with a high return. But they seem to be riskier than a managed fund since a stock (or bond) is never sold from the portfolio, no matter how bad the prospects become. In addition, many of these trusts charge relatively high management fees and sales charges for a fund that, by design, is unmanaged. Moreover, there may be fees for rolling over your money into a new fund and you can only sell your trust units back to the brokerage house or fund managers. While some funds may produce good returns, review all aspects of the trust before investing.
Use in state creates sales tax liability . . . Just because you bought a vehicle, machine, etc. in another state and paid sales tax there doesn't mean your concern should end there. You may owe sales tax on the asset when you bring it into a new state. For example, you purchase a motor vehicle in Massachusetts and pay the 5% sales tax. Some time later you bring the vehicle into New York where the sales tax is 8%. You'll receive credit for the 5% tax paid in Massachusetts, but New York will want an additional 3%. A state may want to collect sales tax on the asset, even though the use in the state is for a short period of time. The rules vary from state to state, so check with your tax adviser for the rules in the states in which you do business. You can't always avoid the tax, but often a small switch in plans can help you save taxes.
LLCs increasingly popular . . . We've suspected that LLCs (limited liability companies) have become increasingly popular over the last several years. As of 1998 (the latest statistics we have) it appears they now account for some 12% of all new business filings. That's remarkable for an entity that barely existed at all 8 years ago. And it's likely they'll account for even more filings in coming years. But just because they're all the rage doesn't mean they're right for you. Get professional advice before committing to a choice of entity for a new business. Making the wrong choice can be expensive.
Copyright 2000 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536