News On The Tax Front--The latest tax news.
Partnerships and LLCs--Distributions--A distribution from a partnership or LLC can be taxable or nontaxable. And property distributions are much different than cash distributons. You've got to know the rules to avoid some costly tax consequences. A must read for all partners and LLC owners.
Cars--Special Rule for Substantiating Business Use--You may not need to keep a log for vehicle use. Here's one exception to the general rule that could save you time and money.
Travel & Entertainment Tax Traps--Part II--Here are some more travel and entertainment tax traps.
Cash Balance Plans --You've heard of cash balance pension plans. Here's how they work.
In Brief:--Tax, business, and personal finance tips.
Previously Reported In Daily Update
Before going to court, you can take your case to an Appeals Officer in the IRS. Appeals Officers are supposed to be independent. In Notice 99-50 the IRS announced that it is proposing a revenue procedure that is intended to maintain that independence. Basically, the Appeals Officer is not to have communication with IRS employees involved in the case outside of the formal proceedings.
If an overpayment claimed on a return is credited to the succeeding year's estimated tax or refunded without interest, from what date will interest be assessed on a subsequently determined deficiency for the overpayment return year? In Rev. Rul. 99-40 the IRS ruled that interest will be assessed on that portion of a later determined deficiency for the overpayment return year that is less than or equal to the overpayment as of (1) the date on which the IRS refunds the overpayment without interest, or (2) the date on which the overpayment is applied to the succeeding year's estimated taxes. An overpayment applied to a succeeding year's estimated taxes will be applied to the installments in the order they must be paid to avoid liability for the penalty for failure to pay estimated tax. Interest will be assessed on any remaining portion of the deficiency from the original due date of the tax for the overpayment return year. Taxpayers will no longer have the ability to designate how overpayments will be applied to specific installments, but that's no longer necessary.
If you have investments that generate passive losses, you probably want to find investments that will produce passive income. That can produce cash flow at no tax cost since the passive losses will offset the passive income. The approach was not lost on the drafters of the 1986 Tax Act. There's a specific section in the law that provides that rental of equipment or property by a shareholder to a C corporation will not produce passive income. Why? If it did, taxpayers could structure rental agreements with their businesses to produce passive income. In Chester F. and Faye L. Sidell (T.C. Memo. 1999-301) the Tax Court did not allow the taxpayers to use the income from rentals to their C corporation to offset other losses and credits.
The IRS has released three updated publications. Publication 1528 provides a list of vendors who can provide either software or services to enable you to file information returns (Forms 1099 etc.) electronically. Publication 1060, Collection Appeals Rights, explains the types of collection actions and how to request a hearing with the Office of Appeals. Finally, Publication 1045, Tax Professionals Program, contains info for tax professionals on ordering forms, instructions, etc.
If you're unmarried, filing as a head of household is the best tax status. The rates are about midway between single and married. However, in order to use that status, you've got to be unmarried at the end of the tax year and you must maintain as a home a household for more than one-half of the tax year that is the principal place of abode for a son, daughter, etc. In Charles W. Newsom (T.C. Memo. 1999-297) the Court found that the taxpayer was legally married to his spouse for the entire tax year. Even if the taxpayer was unmarried, the Court noted he didn't produce evidence as to the expenses he incurred in maintaining a household.
Generally, you can only deduct expenses that you incur and pay. In Sheryl D. Bumpus (T.C. Memo. 1999-299) the taxpayer claimed a deduction on her personal return for a lease cancellation fee that she paid to release her corporation (she was an officer and shareholder). The Court noted that the corporation's existence was effective as of the date the articles of incorporation were filed. Thus, only the corporation could deduct the expense. Note. What should you do in such a situation? If you pay the expense personally, submit an expense report for the amount and have the corporation reimburse you. If the corporation's short of cash, loan the corporation the necessary funds and have it pay the bill.
While you may be able to take the Fifth Amendment in a criminal trial, it may not be so easy in a tax proceeding. In Insurance Consultants of Knox, Inc. (99-2 USTC 50,791; U.S. Court of Appeals, 7th Circuit) the Court held that an officer of the corporation had to produce the records requested in an IRS summons. The officer couldn't claim the Fifth Amendment right against incriminating himself in connection with corporate documents. In addition, the Court found him guilty of filing a frivolous appeal.
The bank deposits your receipts for the day into the wrong account. Your account isn't credited. Can you take a tax deduction? In Fatai O. and Mary King (T.C. Memo. 1999- 293) that's what happened to the taxpayers. They claimed a theft loss. The Tax Court didn't allow it. The Court said that the taxpayers had a reasonable prospect of recovery in the year they took the loss. Thus, no deduction was allowed.
If you're going to court to challenge the IRS's disallowance of a deduction, make sure you've got the right documentation. In Fatai O. and Mary King (T.C. Memo. 1999- 293) the taxpayers provided the Court with receipts and a canceled check for repairs to an auto. Unfortunately, the Court spotted the fact that the bill and check referred to another car, not the taxpayer's business vehicle. The taxpayers also claimed a deduction for amounts paid to lottery winners at their newsstand. The Court found that checks they represented as paid to those winners showed no evidence of that. Moreover, their testimony was less than convincing. In another issue, the Court found that records purportedly showing repair expenses appeared to be altered.
If you transfer your IRA account to your spouse under a divorce judgment, the transaction is not taxable. That's not what the taxpayer did in Richard David Czepiel (T.C. Memo. 1999-289). He withdrew the funds from the account and gave the cash to his ex-wife. The Tax Court held he was liable for income tax on the distribution and the 10% penalty tax on early withdrawals. Note. This can be a very expensive mistake. Get good advice. Even the transfer of an IRA must be under a divorce agreement.
Property you hold for sale in the normal course of business is considered inventory. Any gain on the sale of such property is taxed at ordinary income rates. On the other hand, gain on property you hold for investment purposes should be taxed at more favorable capital gain rates. Some taxpayers, such as real estate developers, can find themselves in both categories. For example, a real estate developer may purchase some choice land intending to hold it as an investment, or maybe even intending to build his own house on it someday. The sale of that land should produce a capital gain. Another tract of land may be purchased with subdividing and selling individual lots or building and selling houses. The sale of land from that tract will result in ordinary income. In Harry Olstein, Olstein Family Partnership (T.C. Memo. 1999-290) the partnership took title to the lots as the result of a settlement between a partner and a real estate developer. The Court found that while the land might have been inventory property in the hands of the developer, that use should not be imputed to the partnership. Note. Because of the wide disparity between the tax rate on capital gains and ordinary income, make sure the facts are in your favor. Keep good documentation and talk to your tax adviser.
You may have heard about cash balance pension plans. They've been touted as a cheaper alternative to a defined benefit plan. In a defined benefit plan, contributions are based on the employee's salary, age, and length of service. The biggest contributions usually come during the last 5 or 10 years of the employee's time with the company. Cash balance plans favor younger workers because fixed contributions are made during throughout the employee's stay. By switching to a cash balance plan, an employer can save a considerable amount in pension costs, but the employee is likely to end up with a substantially smaller pension than with a defined benefit plan. Up until recently, the IRS has been approving employers' requests for switching from a defined benefit to a cash balance plan. The Service has now instructed field offices to seek advice from the National Office before approving such plans. Employers who might have been considering a switch should think twice. There has been backlash from employees at more than one company that's switched and some have considered age discrimination lawsuits. For more details, see the article in this issue.
In J. David Golub (T.C. Memo. 1999-288) the taxpayer's broker did not liquidate his account when instructed. He contended that the broker's failure to do so resulted in the conversion of the account and made the broker the owner of the income. When the account was finally liquidated, the taxpayer argued the proceeds were restitution. The Court found otherwise. It held the dividends from the stocks in the account were income to him and the proceeds from the sale produced taxable gain.
The Tax Court has noted that it is getting fed up with taxpayers who have a frivolous position. In J. David Golub (T.C. Memo. 1999-288) the Court imposed a $10,000 delay penalty. The Court noted the taxpayer was a CPA who was knowledgeable about the tax laws. Moreover he failed to report income and claimed grossly overstated deductions.
In Announcement 99-90 the IRS reported that Form 10318, Deduction for Depletion on Ground Water Used for Irrigation, is obsolete. It was previously used by taxpayers who extracted ground water from the Ogallala geological formation for irrigation. Taxpayers claiming this depletion should continue to deduct it on the depletion line of their tax returns. No attachment is necessary.
You can deduct travel expenses incurred while away from home. Often, there's no question as to whether or not you're away from home. For example, you have a home office in a suburb of Boston. While you have a number of clients in the Boston area, you also spend over half the year at locations around the country. You're maintaining a tax home in the Boston area, so your away-from-home expenses are deductible. But what if your home is a motor home and you travel around the country. That was the situation in In re Paul D. Bechtelheimer, Nelda K. Bechtelheimer, Debtors (99-2 USTC 50,781; U.S. Bankruptcy Court, Mid. Dist. Fla.). The taxpayers were itinerant artisans who sold their wares out of their motor home while traveling around the country. While they owned a mobile home in Florida, they spent less than 40 days there during the year at issue. The Court found that this did not qualify as a tax home. Thus, since they had no tax home they were not allowed to deduct their travel expenses.
Generally, you're only allowed a deduction for charitable contributions made to U.S. charities. Special exceptions exist for Canada and Mexico. In Notice 99-47 the IRS released guidance on how charitable organizations of the U.S. or Canada can qualify so that contributions made to them by citizens of the other country will be deductible.
In Announcement 99-93 the IRS reported that the 1998 instructions for Form 8853, Medical Savings Accounts and Long- Term Care Insurance Contracts, and Form 5329, Additional Taxes Attributable to IRAs, Other Retirement Plans, Annuities, Modified Endowment contracts, and MSAs, contain an error.
Having a lender foreclose on property you own may not be the worst of it. For tax purposes a foreclosure is the same as a sale of the property. If your loans are satisfied and there's money left, you could have a gain on the sale. In L&C Springs Associates (99-2 USTC 50,777; U.S. Court of Appeals, 7th Circuit) the taxpayer was relieved of a nonrecourse debt on the property and had to report the amount as income.
You've got to be particularly careful if you're trying to gain special tax benefits. Generally, you've got to make an election on a timely filed return. You should be even more careful if the tax law changes. There may be additional limits. In Irene H. Dzuris (99-2 USTC 50,780; U.S. Court of Federal Claims) the Court denied the taxpayer the benefits of special 10-year income averaging treatment on a lump-sum distribution from a qualified retirement plan. The taxpayer failed to elect special transition treatment under a 1986 law change. She also failed to file a formal or informal claim within the 3-year period after filing the relevant returns.
If you're acting as an executor of an estate get good advice on your responsibilities. In Estate of Florence H. Devida Johnson (T.C. Memo. 1999-284) the personal representative for the decedent's insolvent estate was found to be personally liable for income taxes due on the estate. The representative elected to pay other creditors before the IRS.
If you don't keep good records the IRS can use almost any method the courts have allowed to reconstruct your income. In Andy Rataiczak (T.C. Memo. 1999-285) the IRS used the markup method to reconstruct the taxpayer's income. The Court partially sided with the IRS. It noted the IRS made material mistakes in applying the method, failing to account for theft losses and unsold inventory.
The IRS has published final regulations on the tax treatment of inflation-indexed debt instruments, including Treasury inflation-indexed securities. The regulations include address indexing methodology, the coupon bond method, the discount bond method, and deflation adjustments.
Partnerships and LLCs--Distributions In our last issue we went through the painful task of computing your basis in a partnership or LLC. As we discussed, knowing your basis is important because it will determine the status of distributions (taxable or nontaxable) and whether or not you'll be able to take any losses on your personal tax return. Unfortunately, we ignored some of the finer points. We're going to remedy that now. Please keep in mind that this is by no means a complete discussion of the subject. That would take a rather large book. Instead, we're going to concentrate on frequently encountered traps and questions.
Cash distributions. A partnership or LLC can distribute two types of property to its partners, cash and other property. We'll consider cash distributions first; they're the easiest to understand and most frequently encountered. A cash distribution can be a taxable or nontaxable. If, at the time of the distribution you have sufficient basis to cover the distribution, it's not taxable. If you have no basis in the partnership or LLC, all of the distribution is taxable. In some cases, only part of the distribution may be taxable. If any part is taxable, the gain recognized is treated as if you sold an interest in the partnership.
Marketable securities are generally treated the same as cash. There are three exceptions to this rule, the most important one is if the security was previously contributed to the partnership by the partner receiving the distribution.
Example--Fred Flood is a 50% owner in Madison LLC. His basis is $3,000 at the time that Madison makes a cash distribution to him of $10,000. The rule is that the distribution is nontaxable up to the amount of his basis. Thus, the first $3,000 of the distribution is not taxable. But that distribution reduces his basis to $0. Thus, the remaining $7,000 distribution is fully taxable.
Tax Tip--You can avoid such treatment, but only if you plan ahead. Instead of simply taking a distribution, have the partnership loan you the amount that would be taxable income. In the example above that's $7,000. But remember, it has to be a bona fide loan. That means payment of interest, written promise to pay, etc.
Property distribution. Instead of distributing cash, the partnership could distribute an item of property, for example, an auto. This distribution has no immediate tax consequences. Instead, you have to report a gain when you dispose of the property. The trick here is that your basis in the property depends on your basis in the partnership and the partnership's basis in the property:
Example 1--Fred's basis in Madison LLC is $10,000. Madison has a truck for which it paid $20,000, but which has been depreciated down to $9,000 (its adjusted basis). Madison distributes the truck to Fred. Fred's basis in the truck is $9,000. If Fred immediately sells the truck for $10,000, he'll have a $1,000 gain.
Example 2--Assume the fact's are the same as above, but the truck has been depreciated to $12,000. That is, Madison's adjusted basis is $12,000. Since that's more than Fred's basis in Madison ($10,000), his basis in the truck is $10,000.
Example 3--Assume that Fred's basis in the partnership is $0. Madison distributes a truck to him with a fair market value of $15,000. Fred's basis in the truck is $0. If Fred sells the truck for $15,000, he'll have a $15,000 gain. If he uses the truck in another business, he won't be able to claim any depreciation deductions since his basis is $0.
And, as we said in our last issue, you reduce your basis by the partnership's basis in the asset distributed. In example 2, above, Fred has to reduce his basis by $12,000. But his basis in the partnership is only $10,000, and he can't reduce his basis below $0, so his actual basis reduction is only $10,000. There are some other points here. First, we've assumed that the distributions are not liquidating distributions. In a liquidating distribution, you take your basis in the partnership (after reduction by any money received in the distribution) and spread it over the assets received. And, as opposed to a nonliquidating distribution, a partner can recognize a loss.
Second, we've assumed that any property is in the nature of equipment or similar property held by the partnership, but not unrealized receivables or substantially appreciated inventory (sometimes called "hot" assets). Special rules apply to these assets.
Third, things get more complicated if the asset distributed is subject to a liability. For example, assume the truck in the examples above was subject to a loan and Fred assumed the loan. There are two important consequences. First, every partner is relieved of his share of that partnership debt. That means every partner is considered to have received a distribution of money. Second, the partner assuming the debt is treated as making a contribution to the partnership in the amount of the debt. The result is that every partner can be affected by a distribution to just one of the partners.
Finally, a partnership can make a Section 754 election. If that election is in effect when a partner buys an interest in the partnership, the partnership will step up its basis in the assets for the benefit of the new partner only. If the partner receives assets in a distribution, his basis in the assets will reflect this adjustment. Thus, each partner could have a different basis in the assets. A further discussion is beyond the scope of this article, but you should ask your tax advisor about this election and make sure you understand the consequences when admitting partners or taking distributions.
Tax Tip--Two things should be clear. First, you've got to know your basis before taking a distribution. If you receive a cash distribution that exceeds your basis, you'll have at least some taxable income. Second, taking a property distribution can have many tax consequences, both to you and to your other partners. There may be no tax consequences to you until you sell the property, but there could be immediate consequences to the other partners. That may not be a good thing for partnership harmony.Tax Tip--If the fair market value of the property you want to distribute is less than its basis in the partnership, you've got to do a careful analysis. If your basis in the partnership is lower than the partnership's basis in the asset, you could have a situation where the partnership can't take a loss but you have a gain on the sale of the asset.
Tax Tip--If you receive several noncash assets in a distribution and if the partnership's basis in the assets exceeds your basis in the partnership you must allocate your basis in the partnership among the properties based on the the partnership's basis in each of the properties.
Timing of adjustments. A distribution will reduce your basis in the partnership as will losses the partnership incurs. But which adjustment is made first? The answer is important since it may determine whether or not you can take the losses. Similarly, if you receive a distribution and recognize income in the same year, the order is important.
If you receive advances or drawings against income during the year, such distributions are treated as distributions made on the last day of the partnership year. The same is true of income the partnership earns during the year. This means you adjust your basis upward by the amount of taxable income for the year before your reduce your basis for the drawings or advances. Keep in mind that to qualify as a true draw or advance you must be required to repay any amount in excess of your share of the current year income.
In the case of distributions and losses, you decrease your basis for distributions before losses. This is a benefit since it's less likely that the distributions will result in taxable income.
Tax Tip--Taking distributions to reduce your basis to $0 could be a valuable tax planning tool. You can only take losses in the partnership up to your basis. And distributions of cash that exceed your basis create taxable income. Those two facts can be used to advantage. For example, assume your personal income is very low in 1999. Your partnership has substantial losses. You could wipe out your income for 1999 with the losses, but you know you'll be in the 39.6% bracket next year and the partnership will have substantial profits. By taking a distribution this year you may lower your basis enough so that any passthrough losses won't be deductible but will have to be carried forward. That way you'll use the losses when you need them most, in 2000, when you're in a high bracket. Conversely, if you can use the losses this year because you're in a high bracket, avoid taking a distribution. If your basis isn't high enough to use the losses, consider contributing equity capital or loaning money to the partnership.
Next issue. In our next issue we'll be discussing year-end tax planning tips. We'll discuss the at-risk and passive activity loss rules in the following issue.
Cars--Special Rule for Substantiating Business Use
If you want to deduct expenses associated with the business use of a vehicle, you've got to keep good records. That means employees (and you, if you're an employee, partner, etc.) have to keep a daily log. Well, that's the general rule. There are some exceptions. One little-known exception is that you don't need to keep such records if you have a policy statement prohibiting personal use, or prohibiting personal use with the exception of commuting. But don't throw those log sheets away until you've read the rest of this article.
Vehicles not used for personal purposes. If you have a policy statement prohibiting personal use and you can meet all the following conditions, you won't need logs. You must be able to show:
The first item needs no explanation. The second is also pretty clear. The vehicle must be parked on the business premises when not in use. That means at the end of the day, weekends, etc. Business premises can include the parking lot next to the store, a lot down the street where the company parks the vehicles, etc.
The third item is just a loophole closer. It was written to prevent you from using this exception if you claim your home as a business location. For example, you have 4 employees, including yourself, and operate out of your home. Each of you has a company vehicle that's used in the business. The other 3 employees are unrelated to you (i.e., live elsewhere). You could use this written policy exception for those 3 employees, but you would still have to keep a detailed log for your vehicle use.
The fourth item is pretty clear, except for the de minimis rule. Similar rules appear in other areas of tax law. De minimis personal use means the vehicle's use for personal purposes is so small a portion of the total use as to be negligible. For example, the vehicle is driven an average of 70 miles per day. Different side trips each day for a daily total of, say 2 miles, would probably be de minimis. However, the same side trip each day, say to pick up your son from school, might not be. A longer side trip for lunch each day might be de minimis if there was no place to grab lunch because the employee was on a highway, etc. The idea here is to keep such trips to a minimum. You don't want to test the rules.
The last item is very important, and another loophole closer. You, as the employer, have to reasonably believe there is no personal use (except for de minimis use) by the employee or a personal related to, or a friend of the employee. (If a relative or friend uses the vehicle, the vehicle use will be imputed to the employee.) If the employee provides the vehicle to another employee for use in the business, that's ok. You can't squirm out of 'reasonably believe' by ignoring violations of the policy. The regulations contain a phrase saying "there must also be evidence that would enable the Commissioner to determine whether the use of the vehicle meets the five conditions." And, while the other conditions are reasonably easy to police, this last requirement isn't. Unfortunately, there isn't any guidance in the regulations.
What you can do to support the fact that you reasonably believe there is no personal use depends on your particular situation. If, for example, your business consists of regular delivery routes, you could have employees provide a log for a representative period, one day for daily routes, a week for weekly routes. The log would show the breakdown of personal vs. business mileage. You could then check odometer readings at regular intervals (say, every two months) to see if there's more mileage when logs aren't requested. In other situations, for example, where there's no regular route, you could also check the mileage for one day or a week, then ask employees to substantiate the mileage driven. Talk to your tax advisor. You don't have to account for every mile or make sure that no employee has any personal use. You just have to reasonably believe there is no personal use.
Vehicles not used for personal purposes other than commuting. If the vehicles are not used for personal purposes other than commuting, you can use a similar approach. The policy statement is slightly different. The following conditions (some are similar to those above) must be met:
Again, there must be evidence that would enable the Commissioner to determine whether the use of the vehicle met the preceding 6 conditions.
The second item needs some explanation. What's a bona fide noncompensatory business reason? You might not, for example, be able to leave the vehicles on company premises overnight. That could be due to a lack of parking, local ordinance, or risk of theft or vandalism. Or, employees could be on call, even while commuting to and from work. There can be other reasons. (The noncompensatory part is to exclude those situations where you provide an employee with a car as a perk.)
The fifth item also needs some explanation. A control employee is any employee:
Clearly, that effectively rules out using this exception for owners and many officers.
The final requirement is straightforward. You must include the commuting value of the vehicle in the employee's income. That's $1.50 per day, per trip. Thus, for each daily round-trip, you'd have to include $3.00 on the employee's W-2. There's no adjustment here for distance. If the employee lives 1 mile from work, too much will be included in his income. If he lives 20 miles away, he comes out way ahead.
In the discussion above, a sole proprietor is treated as both an employer and employee, a partnership is treated as an employer of its partners and a partner is treated as an employee of the partnership.
Policy statement. We've drafted two policy statements you can use. See Policy Statement for Vehicles not used for Personal Purposes and Policy Statement for Vehicles not used for Personal Purposes Except Commuting.
Additional points. You don't have to use this approach for all employees. You can use the method for some employees and require logs for others. The method makes the most sense for employees who can be easily monitored (e.g., those with set routes) and those who are unlikely to use the vehicle for personal purposes (e.g., those who have a van with the company's logo all over it). Finally, talk to your tax advisor before implementing.
Travel & Entertainment Tax Traps--Part II
In the last issue we discussed some tax traps related to travel and entertainment. Taking your spouse on a trip if he or she isn't an employee, skyboxes, tickets purchased for more than the face value, etc. In this issue we'll continue with some other traps.
Conventions. In order to be deductible, any convention or seminar has to be deductible as a trade or business expense. Expenses related to seminars for investment purposes are not deductible. The nondeductible expenses include travel, lodging, meals, and the cost of the seminar itself. Thus, none of the costs associated with seminars related to investments, financial planning, or income producing activities (rental of property where it's not a trade or business) are deductible.
Seminars for job-related education are deductible, but you must meet certain tests. First, there must be bona fide educational seminars and they must be for more than a nominal portion of the stay. For example, the IRS will al disallow a deduction if you spent 1 hour per day in education and the rest lounging on the beach. When Congress wrote the law, they gave an example of situations where a deduction would be denied if participants simply showed up and received a videotape to take home.
Second, the seminar must meet the other tests for deducting education expenses. That is, if your company pays the expense and the topics are related to your current job, the company can take a deduction. If you pay for the seminar personally you can deduct the expenses on your personal tax return (subject to the 2% floor), but only if the course work is to maintain skills in your present job. If it could qualify you for a new job, no deduction is allowed.
Conventions on cruise ships. You can deduct conventions and seminars on cruise ships, but only if:
The reporting requirements referred to above require you to attach two written statements to your tax return for the year in question. The first must include information with respect to the total days of the trip, the number of hours of each day of the trip that you devoted to scheduled business activity, and a program of the scheduled business activity of the meeting. You must sign that statement. The other statement must be signed by a representative of the sponsoring organization or group and must include a schedule of the business activity of each day of the meeting and the number of hours during which the individual attending the meeting attended such scheduled business activities.
Even if you meet all these requirements, your deduction is limited to $2,000 per individual, per year. If both you and your spouse meet all the requirements, you can deduct $4,000 on a joint return.
Foreign conventions. The rules here can be complicated enough so that we could devote an entire article to just this one topic. We'll just deal with the highlights.
The general rule is that no deduction is allowed for expenses for a convention, seminar, or similar meeting held outside the North American area unless, taking certain factors into account, it is as reasonable for the meeting to be held outside the North American area as within it. The factors to be taken into account in determining the reasonableness are:
The North American area includes the U.S., its possessions, Canada, Mexico and certain beneficiary countries. Beneficiary countries include Barbados, Bermuda, Costa Rica, Dominica, Dominican Republic, Grenada, Honduras, Jamaica, Saint Lucia, and Trinidad and Tobago (this is not a complete list).
Luxury water travel. If you were considering taking a ocean liner, cruise ship, etc. to get to a convention, business meeting, etc., you might want to reconsider. Your deduction is limited to twice the aggregate per diem amount allowable for executive branch government employees serving in the U.S. times the number of days en route. The per diem amount is the highest travel amount paid to executive government employees with respect to travel in the contiguous United States. That doesn't include special exceptions that could be higher (e.g., for high-ranking employees). Furthermore, before applying the per diem limitation, any separately stated expenses for meals or entertainment must be reduced for the percentage reduction rule for such expenses, that is, 50%.
Per diem rates change regularly, but using $230 as a guide, should the trip take 5 days, your deduction for the voyage would be limited to $230 X 2 X 5 or $2,300. There are some exceptions to the rule.
Foreign business travel. This is a complicated area. We'll cover it in some depth in our next regular issue, November 1, 1999.
The IRS is seeking public comments regarding potential issues arising under their jurisdiction with respect to cash balance pension plans, particularly with respect to conversions of other types of defined benefit pension plans into cash balance plans.
A cash balance plan is a defined benefit pension plan that typically defines an employee's retirement benefit by reference to the amount of a hypothetical account balance. In a typical cash balance plan, this account is credited with hypothetical allocations and interest that are determined under a formula set forth in the plan. The crediting of hypothetical allocations and hypothetical interest has been described as resembling the allocation of actual contributions and actual earnings to an employee's account under a defined contribution plan, such as a profit-sharing plan.
In recent years, existing defined benefit plans covering a significant number of employees have been changed into cash balance plans. This change, made by amending the existing plan, is commonly referred to as a conversion. In a conversion, the new cash balance benefit formula generally applies to new employees and may also apply to employees who had already earned benefits under the plan before the conversion. The law protects benefits earned before the conversion by prohibiting a plan amendment that reduces those benefits.
In some conversions, however, employees who had already earned benefits may not earn addition retirement benefits for varying periods of time after the conversion. This effect, often referred to as a "wear-away" or "benefit plateau" continues until an employee's benefit under the ongoing cash balance formula "catches up" with the employee's protected benefit.
Generally, younger workers who switch jobs relatively frequently do better with a cash balance plan. Employees who stay with the company for, say 30 years, do significantly better with a traditional pension plan. However, if they leave before about 20 years of service, they'll often have a very small benefit from a regular plan.
For the company, there's no question a cash balance plan is cheaper if there's a high proportion of older employees. A cash balance plan also makes sense if you need such a plan to be competitive in the labor market for young employees. For example, you're unlikely to lure high-tech employees to your company by touting a defined benefit pension plan.
While there are a relatively small number of cash balance plans in operation, they have been adopted by some large corporations. That means a substantial number of individuals may be affected. Congress is taking a look at these plans to determine what, if anything, they might do to restrict their use or to insure that employees covered under existing plans may elect to continue to be covered under those plans if the employer switches to a cash balance plan.
Starting a pension plan of any sort is a significant commitment. You don't want to make a mistake; there are substantial legal and human relations problems from dropping a plan. Get good advice from a pension expert and your accountant and attorney.
Previously Reported In Daily Update
Acquisition sold at a loss . . . On September 28, 1999 the Wall Street Journal reported that Kellogg was selling its Lender's Bagels unit for $275. Kellogg bought the unit 3 years ago for $466 million. It announced it was taking a $170 million charge to earnings. On the surface the acquisition made sense. Kellogg's breakfast food market was being attacked by bagels. Buying a competitor seemed like a good idea. Unfortunately, both Kellogg's breakfast cereals and Lender's bagels are sold in grocery stores. While people were eating more bagels, they were buying them at delis, bagel shops, etc. from the road. Not every acquisition turns out bad, and few turn out this bad. But the converse is also true. Not every acquisition results in increased profits, much less a good return on the investment. Think it through and get good advice. Sometimes not doing anything is the better choice. And make sure you can walk away from any mistake without putting the company at risk.
Excessive compensation in an S corporation . . . While excessive or unreasonable compensation is a problem for regular corporations (the amount over what the IRS or court considers reasonable is a dividend, taxable to the employee/owner, but not deductible), even most professionals never consider it as a problem for S corporations. That's because even if some of the salary were disallowed, it wouldn't have any real tax consequences. (There could be a problem if the S corporation were once a C corporation.) But there's a fine point in the law. If the excess salary is really a way of providing the shareholder/employee with an additional return on his equity investment over what other shareholders are receiving, the IRS can claim there's a second class of stock. That would terminate the S election. And that can have serious consequences. While there haven't been any cases on this issue yet, you don't want to be the first. Refer your tax advisor to Reg. Sec. 1.1361-1(k).
Two trusts reduce stock valuation . . . If you're like many small business owners, your estate will consist largely of stock in your business. If you hold only a minority stake in the business (less than 50%), any valuation of your stock for estate tax purposes can be reduced by a minority discount. In a recent case a husband and wife owned 55.7% of the stock of a business as community property in a revocable inter vivos family trust. When the husband died, he left his half interest to a irrevocable marital trust (a qualified terminable interest property trust) for his wife's benefit during her life. In addition the wife moved her share of the stock from the family trust and contributed to another revocable trust. The estate took a minority discount, arguing that the two trusts were separate entities. The IRS argued that they should be merged for valuation purposes and increased the value. The taxpayer won in Tax Court and the IRS has now acquiesced (agreed to the decision). It agreed that stock in a QTIP trust shouldn't, for valuation purposes, be added to stock in a revocable trust. The result? The taxpayer's valuation was about 43% lower than the IRS's. Reducing your interest in the corporation before your death and/or setting up more than one trust could allow you to claim a substantial minority discount. Talk to your tax advisor. Refer him to Estate of Mellinger, 112 T.C. 26.
Unannounced warranties . . . Got a problem with a car, machine, computer, etc.? You may be out of warranty, but don't automatically assume that repairs won't be covered. Contact the dealer and/or manufacturer. There may be a manufacturing defect that may be partially or totally covered even though the regular warranty has expired. And don't give up if the first person you talk to says nothing can be done. Ask for a supervisor. You're more likely to get satisfaction if there's a manufacturing defect or wear is much faster than normal. The manufacturer may not want to admit to the defect or put out a general recall, so they will do the repairs without admitting there's a problem. You're on even better ground if the problem is safety related. It's worth a try.
Buying a business? . . . In addition to the obvious due diligence work of your financial analysts, accountants and attorneys, check out the company's products or services. If the products are available, buy the product and use it. If the company provides a service, get one or more of your employees to purchase the service. Or ask employees if they've used the product or service. In the case of industrial products, there's a good chance you've got a business associate, customer, etc. that's been a customer of the prospective acquisition, or has some opinion. The financials may look great, but you don't want to buy a company that has a load of customer complaints stuffed in the closet.
De facto layoffs . . . If you lay off or fire an employee (without good cause) the individual is generally entitled to unemployment insurance. On the other hand, if the employee quits, he's not entitled to such benefits. What happens if you demote an employee? This can be deemed to be a layoff. For example, you reduce the employee's hours from 40 to 35, cut her pay from $12 to $10 per hour and downgrade her title. The employee leaves and files an unemployment insurance claim. The changes might be sufficient to allow the employee to be eligible for unemployment compensation. The rules vary from state to state and there are many gray areas. Best advice? Consult an attorney, your state unemployment office, etc.
Selling your business? . . . When capital gain rates were higher it made more sense to use an installment method to sell your business. That approach may now prove more expensive. Even if you have to pay somewhat more in taxes, getting all cash up front means you don't have to worry about the financial future of the buyer. It might even make more sense to settle for a lower selling price to get an all cash deal. Each offer has to be carefully evaluated. But keep in mind that, despite the robust stock market, many individual companies have seen their stock price fall. Get good advice.
Muni bond returns attractive . . . Municipal bonds have two advantages. The interest is generally tax exempt and the bonds are relatively risk free. The disadvantage is that they pay less interest than fully taxable bonds. The trick is to weigh the lower interest rate against the tax savings. Right now such bonds are particularly attractive. The interest rate spread relative to Treasury bonds (which are taxable on your federal return, but exempt for state purposes) is only a few percentage points. That is, a tax exempt municipal bond is paying nearly 95% of what a Treasury bond is earning. But not all municipal bonds are created equal. There's a big variation in risk. Bonds issued by a state and carrying its full faith and credit are the best. A revenue bond issued on a local hospital can be very risky. Talk to your investment advisor.
Full deduction for meal expenses . . . The general rule is that only 50% of all meal and entertainment expenses are deductible. There are exceptions. One important one involves independent contractors. If you bill your customer for your expenses along with your fee for services or time and materials, you can deduct 100% of all meal (and entertainment) expenses if, and only if, you provide "adequate records" to your customer. Adequate records means an account book, diary, log, etc. that contains the date, place, time, business purpose, etc. of the expenditure. In short, you've got to account to the client in the same way an employee would have to account to his employer. In a recent legal memorandum (ILM 199935057) the assistant to the IRS branch chief concluded that a general contractor failed to provide the required documentation to his client. Instead, all he provided was a general statement of travel expenses incurred. (E.g., Meals, $695.) Why pass up a 100% deduction? If you and the client have agreed that you are to be fully reimbursed for T&E expenses, you might as well get a full deduction.
Private mortgage insurance . . . If you put less than 20% down on your home and had a private mortgage, you probably make monthly payments for private mortgage insurance (P.M.I.). Some homeowners have continued to pay such premiums long after their equity has risen substantially. The Homeowners Protection Act took effect in late July. It gives homeowners the right to cancel their mortgage insurance once the equity in their homes reaches 20%. And, cancellation should be automatic if your equity reaches 22%. Check with your mortgage company, CPA or financial advisor to see what your rights are.
Corporate minutes . . . Most small businesses don't keep them. But they could be very important. If you're audited by the IRS, it's almost a certainty the agent will ask to see them. And, if you want audited financial statements for a loan, to go public, etc., the auditors will ask for them. They'll probably also be requested if you try to sell your business. Sure, in a small business they may be perfunctory, but you may need them some day and then it'll be too late.
Copyright 1999 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536