News On The Tax Front--The latest tax news.
Travel & Entertainment -- Foreign Travel--Having your vacation travel expenses deductible is possible, if you know the rules.
At Risk and Passive Activity Rules--If you've got an interest in an S corporation, partnership, or even a sole proprietorship, this is a must read. A mistake here could result in a big tax bill.
Welfare-to-Work Credit--If you hire employees who qualify, you can get up to half of your wage outlay back as a tax credit.
Assignment of Income--You can't avoid being taxed on income by simply giving it away to another party.
In Brief:--Tax, business, and personal finance tips.
Previously Reported In Daily Update
You work in two locations and have two residences, one in Boston and the other in Albany, NY. You've got a business in Boston where you work 4 days a week. You've got your main home where your family lives, in Albany where you do consulting work on Fridays. You stay with your family on the weekend and return to Boston Monday morning. Can you deduct your expenses traveling to Boston and the cost of an apartment there? Those were essentially the facts in James Lawton Robertson (99-2 USTC 50,875; U.S. Court of Appeals, 5th Circuit). The Court found that Boston was the taxpayer's main place of work and, thus, his tax home. The Court held that living expenses in Boston were not deductible.
Real estate developers are often in a unique position. Property they hold for investment may produce long-term capital gains. Property they hold for development or resale produces ordinary income. Usually, the IRS tries to show that the property was held for sale in the ordinary course of business. That means any gains will be taxed at ordinary income rates. In this case the IRS took the opposite tack. The property had declined in value so the IRS argued that the property was held for investment and only allowed a capital loss. The taxpayer argued otherwise. The Court sided with the taxpayer, finding that she was in the business of selling the lots owned by her late husband, a developer. Thus, the losses were ordinary. Margaret Hancock, T.C. Memo. 1999-336.
The IRS Director of Employment Tax Administration and compliance, speaking at the AICPA's Tax Division meeting, said that the IRS will no longer revoke a business's Tip Reporting Alternative Commitment Agreement (TRAC) solely because employees are not reporting their tip income accurately. In addition, TRAC agreement procedures have been extended to May 31, 2005.
The IRS levies your bank account. Can things get worse? You bet. In Mark E. Schroeder (T.C. Memo. 1999-335) the IRS levied the taxpayer's IRA. Then the Service said that was a distribution, fully taxable to the taxpayer. The Court sided with the IRS. In addition, if the distribution occurs before the taxpayer reaches age 59-1/2, the amount is subject to the early distribution penalty.
Just because the IRS used one approach to reallocate royalty and management fees among related corporations when it prepared the deficiency notices and another way when it presented its case in Court, that didn't automatically rebut the presumption that the IRS was wrong. H Group Holding, Inc. and Subsidiaries, T.C. Memo. 1999-334.
The IRS has broad powers to reallocate income among related entities. That's most frequently done when some of the entities involved are foreign based. Usually, that's the area subject to the most abuse and where a taxpayer can avoid more taxes. But in this case H Group Holding, Inc. and Subsidiaries (T.C. Memo. 1999-334) the taxpayer was able to show the IRS was wrong on several issues when it came to royalties and services between foreign and domestic corporations.
In Rev. Proc. 99-39 the IRS provided the requirements of the Form 941 e-file Program, which combines the Form 941 Electronic Filing (ELF) Program with an on-line filing program that allows a taxpayer to electronically file a Form 941 using a personal computer and commercial tax preparation software.
In Internal Revenue News Release IR-1999-77 the IRS announced that, to improve service to taxpayers, it will unify customer service operations at 25 telephone and correspondence sites across the nation into one management structure. The new organization--covering customer service operations at existing IRS Service Center and District sites nationwide--is designed to improve customer service. The change is effective immediately. The objective is to route calls to where trained people are available to service taxpayers. Submission Processing sites will specialize in issues involving tax processing, including areas involving tax forms, payments and deposits. Customer Service sites will specialize in assisting taxpayers by telephone and correspondence. IRS employees will help taxpayers on matters ranging from understanding tax laws to resolving problems with their accounts.
The IRS has broad powers to obtain documents from third party recordkeepers. Usually that's a bank or other financial institution and the IRS seeks records of deposits and withdrawals, interest earned, etc. A summons to get records from a third party recordkeeper is usually upheld by the courts. In this case the recordkeeper was not a financial institution, but a company associated with the taxpayer. The IRS requested copies of canceled checks issued to or for the benefit of the taxpayer, and written contractual agreements relating to the taxpayer for a year at issue. The taxpayer sought to quash the motion in Bruce B. Reimer (99-2 USTC 50,866; U.S. District Court, East. Dist. Calif.). The Court held the taxpayer could not challenge the summons. It found the taxpayer had no proprietary interest in the documents sought and the records were business records the company had in the ordinary course of business. Moreover, the Court found the company did not qualify as a third- party recordkeeper, so the IRS did not even have to give the taxpayer notice of the summons and could not bring a proceeding to quash the summons.
A court can grant summary judgment if there is no genuine issue of material fact and the moving party is entitled to summary judgment as a matter of law. The court must ascertain whether the evidence presents a sufficient disagreement to require submission to a jury or whether it is so one-sided that one party must prevail as a matter of law. In Ronald Girvin (99-2 USTC 50,865; U.S. District Court, So. Dist. Ohio, West. Div.) the taxpayer claimed that he did not receive notice of a levy; the IRS argued to the contrary. The Court refused to grant the IRS summary judgment against the taxpayer, finding that there was enough of a question to let a court decide.
Each year the pension plan limits (e.g., limit on 401(k) contributions, annual compensation limit, etc.) are adjusted for inflation. The IRS just announced (IR-1999-80) the limitations for the year 2000. Here are the most important ones (numbers in parenthesis are for 1999; for code section junkies, we've included significant references):
--Limitation on annual benefit under a defined benefit plan
(Sec. 415(b)(1)(A)) is increased to $135,000 ($130,000).
--Limit on contributions to defined contribution plans
remains at $30,000.
--Definition of highly compensated employee (414(q)(1)(B) is
$85,000 ($80,000).
--Annual compensation limit (401(a)(17) and 404(l))
increased to $170,000 ($160,000).
--Compensation floor for simplified employee pensions (SEP)
is $450 ($400).
--Compensation limit for SIMPLE accounts (408(p)(2)(A))
remains at $6,000.
--Limit on deferrals under deferred compensation plans for
state and local governments (457(b)(2) and (c)(1)) remains
unchanged at $8,000.
--Limit on deferrals under 402(g)(1) and 402(g)(3) (401(k)
plans) increased to $10,000 ($10,500).
--The compensation amounts under sections 1.61-21(f)(5)(i)
and (iii) concerning control employees have increased to $75,000
($70,000) and $150,000 ($145,000).
Tax law mandates a penalty for failure to pay a tax assessment within 10 days of the notice and demand, unless it is shown that the failure is due to reasonable cause and not due to willful neglect. In John R. and Joyce A. Duncan (99-2 USTC 50,864; U.S. District Court, Dist. Ore.) the taxpayer failed to pay the assessment. The Court found that financial difficulties did not prevent them from paying the tax. It noted that they paid over $45,000 to their attorney and $52,000 to their accountant instead of paying the IRS. The Court also noted that they sold real estate and had substantial equity in a beach home and condo that they did not use to pay the IRS. The Court upheld the failure to pay penalty.
In another alimony vs. child support issue, the Tax Court held that payments the taxpayer received from her ex- husband were child support payments since they would not terminate on her death. While the payments could be modified on her death (as provided under state law), they would probably not be terminated. Marie A. Gonzales, T.C. Memo. 1999-332.
You may be mad at the system and want to go to court before exhausting your remedies in the IRS system, but that's not a smart move. In Pedro and Maria Salas (99-2 USTC 50,857; U.S. District Court, So. Dist. N.Y.) the Court held that the taxpayers could not get a refund of amounts the IRS had levied on from their bank account. The Court found the taxpayers had not filed a refund claim before going to court.
If you have two or more activities that can be attacked by the IRS as hobby losses, you've got to be particularly careful. The IRS could deny the losses associated with the losing activity while taxing the profits from the other activities. That's the worst of all possible worlds. And simply putting the two activities on the same Schedule C won't automatically solve the problem. If the two activities are different, you'll need to file two Schedule Cs. That was the situation in Mary Ann Tobin (T.C. Memo. 1999-328). However, the taxpayer was able to convince the Court that a public display garden and a farming operation were sufficiently related to be one activity.
The IRS is always quick to disallow a deduction and force taxpayers to capitalize an expense. In Merlin A. and Dee D. Steger (113 TC--, No. 18) the taxpayer was an attorney who retired during the tax year. He deducted the entire premium on a nonpracticing malpractice insurance policy in the year he ceased doing business. The IRS argued the amount should be capitalized and deducted over several years. The Court sided with the taxpayer. It found the full amount was deductible in the year he ceased doing business.
If you win a settlement for personal injury (you hurt your back at work, you're injured in a car accident, etc.) amounts you receive are generally tax free. But if you just receive a lump sum as a severance payment, the full amount is generally taxable income. In James W. Taylor (T.C. Memo. 1999-323) the taxpayer received a lump sum in exchange for signing a release of claims against his employer for an injury he sustained on the job. He could not prove what percentage of the claim, if any, was compensation for his injury and what percentage was for other claims. The Court held the full amount was taxable.
In another hobby loss case (Robert Bryan Hudnall and Victoria A. Hudnall; T.C. Memo. 1999-326) the Court disallowed their horse-related farm losses. The Court noted they did not substantiate their expenses. The lack of documentation suggested to the Court that their was also a lack of profit motive.
The IRS just announced that it is extending the deadline for taxpayers who want to recharacterize Roth IRA conversions or other contributions to a Roth IRA for tax year 1998 if the recharacterization occurs before December 31, 1999. That includes conversions to a Roth that may have been ineligible because your AGI exceeded the $100,000 cutoff. In order to be eligible to make the recharacterization, you must have filed your 1998 return on time (that includes extensions). If you recharacterize a conversion, you must file an amended 1998 return to reflect that change. Note, a recharacterization of a Roth is the process of undoing a conversion from a regular IRA to a Roth. In order to recharacterize a Roth, you must notify the Roth IRA trustee, provide the trustee with any information he requires, and the trustee must make the transfer.
The IRS has announced (Announcement 99-95) that, because the number of taxpayers signing up for Medical Savings Accounts (MSAs) is far below the cutoff point for October 1, 1999 (the cutoff point is 750,000; only 44,784 are anticipated). Thus, the program's cutoff year will be 2000.
Travel & Entertainment -- Foreign Travel
Special rules apply to foreign business travel. In addition to complying with all the regulations that apply to domestic travel, additional rules apply. The complexity is directly proportional to how much nonbusiness time is involved. Basically, you may not be able to deduct all of your travel expenses (transportation, meals, etc. while actually in transit). We'll start with the easiest rules and work our way up.
Quick review of allocation rules. Even in the case of travel in the U.S., if a trip is partly business and partly pleasure, you must allocate certain expenses. Briefly, you can only deduct meals and lodging for business days and you can only deduct travel to and from the business destination. Side trips for pleasure are not deductible. For example, you travel from Houston to Boston on business. While there you rent a car for the sole purpose of taking a trip to New Hampshire to visit friends. While in New Hampshire you stay overnight. While you can fully deduct the airfare to and from Boston, and meals and lodging there, you can't deduct the cost of the side trip to New Hampshire. Of course, not all situations are that simple, but that's a good, quick overview of the rules.
No special allocation necessary. The same general rule applies to foreign travel, that is, side trips aren't deductible. But you've also got to determine whether or not all your travel expenses (airfare, etc.) to and from the business destination are deductible. Fortunately, there are some safe harbor rules under which you may qualify--
The first exception is simple. Fly to Europe for a business trip (visit a supplier, customer, etc.) and get back within one week and you can spend as much time as you want in nonbusiness activities, the allocation rules don't apply. Thus, you could go on a 6-day trip and spend 4 days on pleasure. The airfare, etc. is fully deductible. (Caution. Be sure you can justify that you were on a legitimate business trip. See below.)
The second exception requires some additional explanation. Generally, you calculate the percentage on a day-by-day basis. That is, a day is either all business or all nonbusiness. If you're away for 10 days and 4 days are determined to be nonbusiness, you're above the 25%. (Note, you can use another criteria other than day-by-day, but you'll have to show the IRS your approach is better.) The problem is to determine what's a business or nonbusiness day. Just because you do some sightseeing doesn't mean it's a nonbusiness day.
Transportation days are generally considered business days. However, if you take a circuitous route to engage in some nonbusiness activity, only the number of days it would take you by a reasonably direct route will be counted as business. For example, you live in New York and have a business meeting in Quebec. Had you driven there directly, the day would be a business day. However, you drive to Ottawa and then to Montreal to visit friends, taking an extra 2 days for the trip. Only the usual one-day time to Quebec is considered a business day.
If your presence is required at a particular place for a specific and bona fide business purpose, the day will be considered a business day, regardless of any other activities. Thus, you're the keynote speaker at the first day of a 5-day conference. You spend 1 hour giving your speech and then spend the rest of the day sightseeing. Your presence is not required until the next day of the conference. That day is a business day even though you only spent 1 hour on business.
Tax Tip--If your actual business time during the day is very small, you should be prepared to document why your presence was required.
A day will be considered a business day if, during hours normally considered to be appropriate for business activity, your principal activity during the day was business related. Again, you don't have to spend 100% of the day working on business in order for it to qualify as a business day. Nonbusiness activity after business hours and/or some nonbusiness activity during the day won't preclude you from counting the day as a business day.
You can also count a day as a business day if on that day you were prevented from engaging in business as your principal activity due to circumstances beyond your control. For example, you scheduled 4 days of meetings with various suppliers during a 5-day workweek. On Tuesday you had planned to spend the whole day with engineers from a supplier. As a result of a crisis at their plant, the meeting was canceled. Even though you engaged in no business, you can count the day as a business day.
Weekends, holidays, etc. may be counted as business days if the days intervene in a regular schedule. For example, you've scheduled meetings beginning Wednesday and going through Tuesday of the following week. There was no reasonable way to shorten the schedule or start the meetings or to begin earlier in the week so as to avoid a weekend stay over. In that situation you can count Saturday and Sunday as business days even if you do no business.
Travel expense entirely allocable to business. There are two other exceptions where you may be able to deduct all the travel expense without having to worry about an allocation. The first situation comes under the heading of lack of control over travel. For business owners and managers this exception probably won't apply. Basically, if, because of your position in the company (e.g., a regular employee) you have no control over the trip, you don't have to worry about allocation.
The second exception is available if you can show that a vacation was not a major consideration. While it sounds easy, you may be better off trying to come under one of the other rules below. That is, showing that most of your days were business days. And there's a catch here. If the trip was primarily personal in nature, the traveling expenses to and from the destination are not deductible even if you engage in business activities at the destination.
Domestic travel excluded. Travel from one point in the U.S. to another point in the U.S. is not considered travel outside the U.S. Thus, travel during that day is not considered in determining whether your travel outside the U.S. exceeds one week. In addition, it doesn't count toward whether the time outside the U.S. attributable to nonbusiness activity constitutes 25% or more of the total travel time. Finally, travel expense related to travel in the U.S. isn't subject to the allocation rules.
Application of disallowance rules. How do you allocate travel expense if you don't come under the safe harbor rules above? Actually, it's straightforward. You simply multiply the travel expense by a fraction, the numerator is the number of nonbusiness days and the denominator is the total number of business and nonbusiness days. You may be able to use another method, but only if you can show that your method is better. That's a tough sell.
Example--You spend a total of 15 days traveling to and from and in Europe. Of those days, 10 qualify as business days. That means 5 of 15 or 1/3 of them are nonbusiness. Your total travel expense was $2,000. Of the total expense, 1/3 would not be deductible.
Final thoughts. Those are the basic rules. It might make good sense to check with your tax advisor before planning the trip.
If you've read the above carefully, you've probably spotted the ways to get your travel deductible and still get in vacation time. There's plenty of opportunity. But the closer you get to the fringes of the rules, the more careful you should be. Keep good documentation of the time spent on business and the total time. Good recordkeeping will often stop an agent from pursuing an issue.
At Risk and Passive Activity Rules
In recent issues we've discussed the basis rules for S corporations and partnerships and LLCs. Most S corporation shareholders and partners will be limited in their deduction for passthrough losses by the basis rules. That is, they won't have enough basis (investment) in the entity to deduct the losses. But there are two additional tests that could limit your deduction of losses. The first is the at-risk rules, the second the passive activity rules. Both are complex areas of tax law. We won't try to explain all the details. Rather we want to alert you to some of the traps. You'll have to consult your tax adviser on the fine points.
Amount at Risk
The basics. In the simplest cases your amount at risk should be equal to your basis in the S corporation or partnership. For example, you put $10,000 into an S corporation and loan it another $15,000. Ignoring any income or losses that increase or decrease your basis, your basis is $25,000. In this example, that's also your amount at risk.
But your basis and your amount at risk can diverge if you start to engage in more complex transactions. That's more true in the case of a partnership than in an S corporation. Here are some common examples.
Nonrecourse loan. Amounts you put up as equity or loan to an S corporation or partnership don't count as an amount at risk if you're not personally liable for repayment of the loan. If you're borrowing from a bank or other financial institution that's generally unlikely. Most lenders will require you to be personally liable. However, if you borrow from some other sources, that may not be true. Similarly, if a partnership or LLC borrows money and the partners are not personally liable, the loan will not increase their amount at risk.
There are two exceptions to this general rule. First, even in the case of a nonrecourse loan, the amount of the loan will increase your amount at risk if you pledge property that is not used in the activity. But the amount at risk won't exceed the net fair market value of the property.
Example--Fred borrows $50,000 on a nonrecourse basis and contributes the money to Madison, Co., a partnership in which he has an interest. While Fred is not personally liable on the note, he pledges his boat as security. The fair market value of the boat is $100,000, but there's a $65,000 loan outstanding. Thus, the net fair market value of the boat is only $35,000. Fred's amount at risk (for this contribution) isn't $50,000, but only $35,000.
Moreover, in this example Fred's amount at risk will automatically fluctuate with the net fair market value of the boat. If the market value of the boat increases to $120,000, the net fair market value will exceed his contribution to the partnership, so the entire $50,000 would be at risk. Repayment of the loan would also increase his amount at risk. Conversely, if the fair market value should fall, his amount at risk would decrease.
If you pledge assets used in the activity, for example, if Fred pledged a machine used in Madison's business, your amount at risk won't increase.
There's a second exception. It's called qualified nonrecourse financing. The funds have to be obtained from a bank or similar lender or from a related party (family members, fiduciaries, and corporations or partnerships in which a person has at least a 10% interest) where the terms are commercially reasonable and similar to those from an unrelated party. In addition, nonrecourse financing is at-risk money only if the funds are used for the holding of real property.
Note. The property securing the loan must have a readily ascertainable fair market value.
Borrowings from persons having an interest in the activity. You can't increase your amount at risk if you borrow from someone who has an interest in the activity, except as a creditor. The lender will be considered to have an interest in the activity if he has a capital interest or an interest in the net profits of the activity.
Example--Fred Flood is a dealer who sells some machinery to Madison Co., a partnership. Madison pays Fred $50,000 in cash and executes a note for $100,000 payable to Fred. The three partners in Madison each assume personal liability for repayment of the amount owed to Fred. In addition, Madison enters into an agreement with Fred where he is to get additional compensation equal to 5% of the net profits from Madison's operations. Because Fred has an interest in the net profits of Madison's activity, he is considered to have an interest in that activity other than as a creditor. The loan payable to Fred doesn't increase the partner's amount at risk even though the partners have assumed personal liability for repayment.
There's a way around the trap described above. If, instead of giving Fred a 5% interest in the net profits, you gave him a 1% interest in the gross receipts you could consider the $100,000 loan as part of your amount at risk. An interest in the gross receipts is different than an interest in the net profits.
Protection against loss. If you're protected against an economic loss through any sort of device, you're not considered to be at risk for that amount. In the case of organized tax shelters, the IRS is on the alert for such devices. They can take the form of circular financing agreements. In a regular operating partnership you may encounter a different device. Usually, each partner is liable for his share of a loan. For example, you have a 60% capital interest in the partnership, you'd be responsible for 60% of any loans. But there may be agreement that provides that the other partners will be called upon to pay the partnership's creditor instead of you should the partnership default on the loan. Since you would be protected against loss, you could not consider your share of the loan to be an amount at risk.
Guarantors. If you guarantee repayment of an amount borrowed by another person for use in an activity, the guarantee will not increase your amount at risk. However, if you repay to the creditor the amount (or a portion) borrowed by the primary obligor, your amount at risk will be increased at the time you no longer have any remaining legal rights against the primary obligor.
Example--Fred and Sue are partners in Madison, Co. Sue contributes $50,000 she borrowed from Portland Bank. Fred guaranteed the loan. Fred's amount at risk isn't immediately increased. However, two years later Sue defaults on the loan and Fred is called upon by the bank to pay the outstanding balance of $30,000. Fred tries to collect from Sue and hires an attorney. Sue declares bankruptcy. There's no chance for Fred to collect. At that time his amount at risk is increased by $30,000.
Contingent liabilities. If you're liable for repayment of an amount borrowed only upon the occurrence of a contingency, you won't be considered at risk with respect to such amount if the likelihood of the contingency occurring is such that you're effectively protected against loss. On the other hand, you'll be considered at risk if the likelihood of the contingency occurring is such that you're not effectively protected or if the protection does not cover all likely possibilities. For example, simply buying insurance protection against certain possibilities won't mean you're not at risk.
Money contributed to the activity. Your amount at risk is increased by the amount of any personal funds you contribute to the activity. However, a partner's amount at risk is not increased by the amount which you are required under the partnership agreement to contribute until such time as the contribution is actually made.
Your amount at risk is not increased by a note payable to the partnership for which you are personally liable until the proceeds of the note are actually devoted to the activity. For example, you give the partnership a note for $50,000. Your amount at risk isn't increased until the note is converted into cash.
Withdrawal of money from the activity. If you withdraw money from the activity, your amount at risk is decreased. Amounts withdrawn include distributions from a partnership, S corporation or sole proprietorship. In the case of an S corporation shareholder, withdrawals include repayments of any indebtedness of the corporation to the shareholder to the extent the repayment decreases the shareholder's adjusted basis of the indebtedness.
Losses also reduce your amount at risk. However, losses can't reduce your amount at risk below zero, distributions can.
See below for some examples.
Recapture of losses. If your amount at risk drops below zero (generally as the result of a distribution), you must recognize income to the extent of losses taken in earlier years.
Some examples will make the last two items clearer.
Example 1--Fred is a partner in Chatham Co. Chatham's sole activity is the rental of real estate. Fred contributed $50,000 in cash to the partnership several years ago when Chatham purchased the building for $500,000. He is not personally liable for the mortgage to the bank. Losses have reduced his basis and amount at risk to zero. However, the building has substantially increased in value so that it's now worth $800,000. Fred and his partner have taken out a second mortgage on the property and intend to distribute $35,000 cash to each of them. The distribution will create a negative amount at risk for Fred of $35,000. That will result in the recapture of losses and he'll have $35,000 of taxable income (all ordinary) in the year of the distribution.
Example 2--Fred is a shareholder in Madison Inc., an S corporation. Fred contributed $10,000 cash to the business and loaned it $50,000 of his personal funds. Madison has had losses and Fred's basis and amount at risk has been reduced from $60,000 to zero. Madison does have cash flow and in the current year repays Fred $5,000 of the loan it owes him. The $5,000 is ordinary income.
Borrowed funds used outside the activity. Your amount at risk is affected by amounts borrowed for use outside the activity where you are not personally liable for repayment of the loan and you've pledged as security only property used in the activity. If that's the case, your amount at risk in the activity is decreased by an amount equal to the amount borrowed for use outside the activity. The result is the same if the only security for the loan is your interest in the activity.
Example--You borrow $75,000 to invest in an S corporation. You're not personally responsible for the loan, and pledge as security your interest in Madison Co., a partnership. Your amount at risk with respect to Madison Co. will decrease by $75,000. (The same result would occur if, instead of pledging your interest in the partnership, you pledge one of the partnership's assets.)
Carryforward and Form 6198. If you can't deduct losses for the current year because you have no amount at risk, the losses can be carried forward and used in subsequent years. If you have amount which is not at risk, you'll have to complete Form 6198.
Summary. While we haven't covered every possibility, we have discussed the ones you're most likely to encounter. You can see that there are plenty of traps for the unwary. While the rules apply to S corporations and sole proprietorships as well as partnerships, there are more ways to run afoul of the rules if you do business as a partnership or LLC.
Passive Activity Rules
If you pass the basis and at-risk tests, you still may not be able to deduct the losses. If the business is a passive activity, you generally can't deduct the losses. Instead, they can be carried forward to offset future income from this or another passive activity or can be taken when you sell your entire interest in the activity.
Inherently passive activity. Some activities are inherently passive. For example, the rental of real estate where you don't provide significant services. There's generally nothing you can do to take the losses currently. In the case of real estate, you may fall under an exception. For example, you can deduct up to $25,000 of losses on real estate rentals if you actively participant in the management (select contractors to do repairs, approve tenants, etc.) and your adjusted gross income is no more than $100,000. Between $100,000 and $150,000, the $25,000 exemption is phased out.
Material participation. In all other types of activities (e.g., a retail store, consulting business, etc.) the activity isn't passive, but you may be a passive investor. For example, you own a 75% interest in a partnership that sells computers. But you've got other business ventures and only spend about 75 hours a year working with the business, and then only as an investor looking over the books, providing general advice, etc. You're not materially participating in the business. If the business has losses, you can't deduct them, even if you have sufficient basis and amounts at risk.
A full discussion of material participation would be very involved. We'll save that for another time. Fortunately, most small business owners will be clearly on one side of the line or the other. If you actively work in the business, at least 500 hours per year, you're probably on safe ground. Work here means getting involved in the day-to-day activities. If your involvement with the business is less, you may still qualify as materially participating, but you've got to check with your tax advisor.
There is a twist here. You may have to look at all the "activities" of the business separately. For example, Madison Inc., an S corporation has a bakery in Boston and a car dealership in Los Angeles. These are two separate activities. If you only worked for the bakery, you might not be able to deduct losses associated with the car dealership. Best advice. Talk to your tax advisor.
Want to hire a new employee and pay him or her only half the going wage? That's essentially what you can do if you hire an employee that qualifies for the welfare-to-work credit. A credit reduces your taxes dollar-for-dollar. That's better than a deduction. How much better depends on your tax bracket. A 50% credit on $10,000 will reduce your taxes by $5,000. A $10,000 deduction will save you $1,500 if you're in the 15% bracket, $3,960 if you're in the 39.6% bracket. Thus, the lower your tax bracket, the more valuable the credit. But claiming the welfare- to-work credit isn't as easy as simply taking a salary deduction on your tax return.
The welfare-to-work credit officially expired on June 30, 1999, but the recently passed tax legislation extends the credit for 30 months. Thus, it applies to qualified individuals who begin work before January 1, 2002.
The basics. The credit is equal to 35% of the qualified first-year wages and 50% of the qualified second-year wages. Qualified wages are wages paid during the year to individuals who are long-term family assistance recipients. The maximum qualifying wages are $10,000 per employee for any one year. The maximum credit per employee is $8,500. And you must reduce your wage deduction by the amount of the credit claimed.
Example--Madison hires Fred Flood, a qualified individual, and pays him $12,000 for the first taxable year. Madison can take a credit on the first $10,000 only. Madison must reduce its wage deduction by the amount of the credit. Thus, of the first $10,000, only $6,500 is deductible ($10,000 less $3,500). The wages in excess of the $10,000 limit, or $2,000, aren't subject to any reduction since there's no credit for them. Madison can deduct a total of $8,500 ($6,500 plus $2,000) of Fred's wages.
Tax Tip--Check the rules in your state. Some states allow a similar credit. If you can't claim a credit, you should be able to deduct the full amount of the wages paid.
Qualifying wages and individuals.
A long-term family assistance recipient is an individual whom the designated local agency certifies as belonging in one of the following groups:
Wages here includes not only regular wages, but also nontaxable amounts relating to accident and health insurance coverage, educational assistance programs and dependent care assistance programs.
Example--Madison hires Fred Flood and pays him $6,000 for the first year. However, in addition to the wages, Madison pays $2,500 toward his health insurance. The total qualifying wages are $8,500.
As long as the worker meets the eligibility requirements outlined above, he could have been employed immediately before your hire him. Thus, two or more employers could claim first- year credits for such an employee. Caution. Special rules apply if the employee worked for a related entity. For example, you own two S corporations and the employee works 3 months for one of the corporations and 6 months for another.
Claiming the credit. To claim the credit, the employer must request and be issued a certification for each employee from the state employment security agency (SESA). The certification proves that the employee is a long-term family assistance recipient. The employer must receive the certification by the day the individual begins work, or must complete IRS Form 8850, Pre-Screening Notice and Certification Request for the Work Opportunity and Welfare-to-Work Credits, by the day the employer offers the individual a job.
If the employer completes Form 8850, it must be signed by the individual and the employer and submitted to the SESA by the 21st day after the individual begins work. If the SESA denies a certification request, it will provide a written explanation of the reason for denial. If a certification is revoked because it was based on false information provided by the worker, wages paid after the date the notice of revocation is received by the employer do not qualify for the credit.
You can claim or elect not to claim the credit any time within 3 years from the due date of your return on either your original return or on an amended return.
Some other requirements:
You must complete and attach Form 8861, Welfare-to-Work Credit to your tax return for any year you're claiming the credit.
Work opportunity credit. This credit is similar to the welfare-to-work credit, but covers a broader group of individuals. We'll discuss that credit in an upcoming issue.
The moral here could be 'no good deed goes unpunished.' You can't avoid paying tax on income you earned by giving the income away. There has to be a valid business reason for splitting your fee, etc.
In a case several years ago (Walton A. Sutherland; T.C. Memo. 1996-1) the taxpayer was an attorney employed by the New York Department of Law. His sister had a daughter who became ill and was treated at a local hospital. Because of mistreatment, the daughter suffered permanent injuries. With the assistance of the taxpayer, the mother engaged a law firm and sued for malpractice. The firm was to receive 1/3 of the settlement and the taxpayer was to receive 1/2 of the law firm's fee. The taxpayer did not appear as attorney of record, but assisted the law firm in reviewing pleadings, etc. Because of his employment with the state the taxpayer could not engage in private practice.
The court in the malpractice case awarded the taxpayer's sister $2.75 million. The taxpayer's share of the fee was $408,000. The taxpayer waived (in writing) his right to the amount, giving it to his sister. The court ordered the amount paid to the sister.
The IRS held that the taxpayer was liable for tax on the income. The Tax Court agreed. It noted that the taxpayer had the right to a 1/2 share in the attorney's fees awarded by the court. It said a taxpayer may not avoid tax by an anticipatory arrangement that assigns income earned by the taxpayer to another.
The Court cited the case of a real estate broker who earned a commission on the sale of a house to his parents. He turned the commission over to his parents and argued that he had agreed to sell the house to them free of commission. The court in that case found he earned the commission and held him liable for tax on the amount.
Most cases revolve around the question if which person in fact controls the earning of the income rather than who ultimately receives the income.
Since the taxpayer controlled the earning of the income, the payment was taxable to him.
Generally, income is taxable to the person who earns it. You may enter into a fee splitting arrangement or pay another party a commission, but you can't arbitrarily assign the income to someone else. In the case of income generated from a property, the income is taxable to the owner of the property. Thus, if you want your son to share in the income from a rental property, you generally must give him an interest in that property. (Caution. Talk to your tax advisor first. There can be gift and income tax consequences.)
Check with your tax advisor. You could get yourself into a no-win situation. For example, what would happen if you assign income to your son and he pays the tax, but you're later audited and the IRS determines you're actually liable?
Previously Reported In Daily Update
Should you trust your broker? . . . There are probably many times when you should listen to your broker. But if the brokerage house has a vested interest in the deal, your broker's advice may be suspect. For example, if you want to quickly get out of an IPO (initial public offering) where the brokerage firm is the underwriter, you may be dissuaded. You might also get jaded advice on other investments sponsored by the firm.
Tax managed mutual funds . . . We've discussed this topic in the past. If a mutual fund sells assets frequently, any gains not offset by losses will generate taxable gains that you'll have to report on your tax return. (The exception, of course, is if you hold the funds in a tax deferred account such as an IRA, Keogh, etc.). Tax managed funds try to reduce the amount of capital gains they have to pass through to the shareholders. Index funds are tax efficient by default. They don't sell shares of the underlying stocks unless the company is dropped from the index, and that's usually infrequent. But how much of a difference is there between an average fund and, say an index fund? Morningstar Inc. recently completed a study that shows that the average diversified U.S. fund gave up 15% of its gains to taxes over a 5-year period while an S&P 500 index fund would have lost only 4%. Averages can be misleading. Some diversified funds have done much worse; some much better. While it's not the only thing to look for in a fund, it should be on your list of considerations.
Vary direct mail campaigns . . . If you do regular mailings to customers or the same prospects, vary your envelope and copy. After the first few times prospects will recognize the style and, may pitch it without opening. Vary the copy inside too. If you've got to continue mailing to prospects who haven't bought in the past (perhaps because your market is limited), you've got to try a different approach. Use your computer to track results.
Gifts or bonus? . . . Two of your employees are getting married to each other. They've been working for you for 12 years and you want to reward them with a $2,000 bonus. Sounds simple enough? But in one case (Webster Tool & Die, Inc. (T.C. Memo. 1985-604)) the IRS found that the company had not intended the amount to be a bonus, but rather a gift. The testimony of one of the corporate officers bore that out. The Court found that the since there was no intent to compensate the employees, the payments were really gifts, subject to the $25 per gift limitation. The company could have gotten a deduction (and the employees would have had income) if they had put something in the corporate minutes indicating a bonus was intended for their long years of service. Check with your tax advisor.
Password protection . . . There are very few businesses that don't need to password protect their computer, at least for some functions. But only a fraction of the number of businesses that should use passwords do use them, or use them correctly. There's a solution for users who don't have the time to properly protect their system. You can now purchase a fingerprint identification pad that can be used as a substitute for passwords. Cost? About $100. That's inexpensive enough to use on every machine.
Check postage costs . . . It may sound petty, but if a number of employees use your postage meter, the costs can start to be significant. Particularly at certain times of the year. You might want to consider tracking your costs. Check the meter at the beginning and end of a day. At the same time check the outgoing mail bin. See what's going out and add up the total. If the postage meter shows much more in cost than the outgoing mail bin, chances are employees are using the meter for personal purposes. Then it's your decision whether or not to take action. You don't have to do it regularly. A test every two months or so should be sufficient. Make sure at least some employees know you're checking. That will act as a deterrent.
Bank charges . . . They continue to increase. Check your statements and any other mailings. Be on the alert for charges to dormant accounts and accounts with low balances. Savings accounts are not immune. Here are some fees we recently encountered on checking accounts:
Nonsufficient funds--$25
Overdraft--$28
Sustained overdraft--$7/day
Post dated checks--$25
Stop payments--$25
Uncollected funds--$25
Monthly service charge on free checking accounts with no activity for 2 months--$4/month
On savings accounts we found the following:
Maintenance fee for accounts with daily balances below $500-
-$5/month
Maintenance fee for accounts with daily balances between
$500 and $1,000--$3/month
Maintenance fee on passbook savings for accounts with
balances below $500--$15/quarter
Fees may be waived for children (usually under age 17 or 18) and for senior citizens. The bank may also waive some or all charges on an individual basis. Ask; it can't hurt.
Prepaid tuition escapes gift tax . . . Generally, gifts in excess of $10,000 per year have gift tax consequences. However, the payment of a relative's medical or tuition expenses don't even come into play when computing the $10,000 limit. They're not subject to gift taxes. In a recent Technical Advice Memorandum (TAM 100041013) a grandmother/decedent entered into a series of tuition payment arrangements with a private school, providing classes for preschool through 12th grade. Under the arrangements, the school sent the decedent an invoice covering tuition for her two grandchildren for multiple years. The decedent made four payments:
February, 1994 for $18,015 for tuition for 1994-1995
June, 1994 for $49,395 for tuition for 1995-1996, 1996-1997 and 1997-1998
February, 1995 for $20,000 for tuition for 1998-1999
July, 1996 for $94,000 for tuition for 1999-2000 and 2000- 2001, 2001-2002, 2002-2002, and 2003-2004.
The payments were not refundable, even if a child ceased to attend the school. In addition, if the cost of tuition increased, the children's father would cover the increase.
The IRS held that the amounts qualified under the tuition exception to the gift rules. Thus, the grandmother was able to transfer $181,000 over a 3-year period, tax free. That could provide estate tax savings of over $90,000. The disadvantage, of course, was that the payments were nonrefundable. That's a significant risk when spread over 13 years. On the other hand, paying for a college education up front may make more sense since the child probably has more incentive to stick it out and the time frame is shorter. Talk to your tax advisor.
Getting paid in company stock? . . . Be careful. Generally, if you receive company stock as payment for goods or services as an independent contractor, the full fair market value of the stock at the time you receive it is taxable income. Should the stock fall in value, you could have a problem. The full fair market value is taxable as ordinary income, but, should the shares later decline in value, any loss would be a capital loss. You could use the loss to offset any capital gains, or you could use up to $3,000 a year to offset ordinary income. That's not a good position to be in. In one case a taxpayer had to report over $110,000 in income one year, only to see the stock become worthless a few years later. Get good advice before accepting stock in payment. There are some options. Talk to your advisor about IRC Sec. 83.
Paying the government may be easier . . . In Internal
Revenue News Release IR-1999-76 the IRS announced that it has
started accepting applications for a new type of Offer in
Compromise plan designed to help some taxpayers facing severe
or unusual economic hardships. For the first time, the IRS will
be able to consider economic hardship factors in cases where
taxpayers try to settle unpaid tax debts through the Offer in
Compromise program and where settlement would promote effective
tax administration. Taxpayers may be eligible for this new
provision if:
Use of old forms doesn't invalidate return . . . You're ready to file your return on the last day and find you don't have the proper forms. In a recent Field Service Advice (FSA 199940009) the IRS held that, despite the use of outdated forms, the return was valid since it contained all the information necessary to calculate the taxpayer's tax liability. The important point was that the taxpayers made a reasonable attempt to report their income and signed the returns. While it's not the best situation to be in, if it's a choice between using an old form and filing late, use the old form.
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