News On The Tax Front--The latest tax news.
Reasonable Compensation--Two recent cases show how one taxpayer lost and one won substantial dollar amounts.
When is a Dividend not a Dividend?--Only the IRS could complicate such a relatively simple issue. It would be funny if the issue wasn't so important in determining the outcome of a number of tax issues.
Extended Out-of-Town Assignment Deductible--Generally, if an out-of-town assignment lasts more than one year, your living expenses at the other location are not deductible. Here's what happened to one taxpayer and how you can avoid an expensive trap.
IRS Statistics --The IRS has just released some interesting statistics on how the new, more helpful, IRS stacks up.
In Brief:--Tax, business, and personal finance tips.
Previously Reported In Daily Update
We've mentioned on more than one occasion that you may be able to avoid the negligence penalty if you rely on an expert. For example, you claim a deduction for certain expenses that the IRS ultimately disallows. If you relied on a CPA, tax attorney, etc. to determine if the deduction was appropriate, you will owe the tax, but not a negligence penalty. But what if you're the expert? That was the situation in Donald Merino, Rosemarie Merino (99-2 USTC 50,940; U.S. Court of Appeals, 3rd Circuit). The taxpayer, a professional engineer with a Ph.D. in managerial economics who worked in the petrochemical industry, was asked to investigate a plastics recycling venture for his CPA. He thought the investment was worthwhile and put his own money into the project. It turned out the venture not only failed to became profitable, it was attacked (successfully) by the IRS as a tax shelter sham. The Court cited a number of reasons that the taxpayer should have been suspicious of the venture. The Court upheld the negligence penalty. Note. The outcome may have been different if not as many factors weighed against the taxpayer. However, even if you're an expert, consider getting a second opinion. The negligence penalty can be substantial.
Because you underpaid some taxes you owe the IRS interest. For another year you overpaid taxes and the IRS owes you. In the past the two could not be netted. As a result of a law change you can now net interest on over- and underpayments. In Rev. Proc. 99-43 the IRS provided additional guidance on these netting rules. The revenue procedure modifies and supersedes Rev. Proc. 99-19.
In some cases you may be able to preserve your rights even if you file a petition late. It's called the doctrine of equitable tolling. However, you've got to be able to show that extraordinary circumstances beyond your control prevented you from filing on time. That wasn't the case in Roderick L. MacKenzie (99-2 USTC 50,932; U.S. District Court, East. Dist. Calif.). The Court found the taxpayer did not exercise due diligence in attempting to file a motion by the deadline.
You can't sue for a refund if you haven't yet paid the tax. That was the situation in Gary Scott Laughlin, Jill Laughlin (99-2 USTC 50,933; U.S District Court, So. Dist. Calif.). The Court found that the taxpayers had to pay their tax in full before filing a claim for a refund.
Almost any money you earn from your labors is subject to the self-employment tax. Thus, if you're a financial consultant for a large corporation, but have just one outside client for whom you provide advice and earn $500, you're probably liable for the self-employment tax on those earnings. To avoid the tax you'd have to show that you're not in a trade or business; that will be hard to do if you perform such services for more than one year. In Tracy Lee Millian (T.C. Memo. 1999-366) the taxpayer was a police officer who worked off-duty as a security guard. He tried to argue that he was still under the control of the police department and, thus, not an independent contractor. The Court did not agree. The department exercised only incidental control over him when off-duty. The income he earned as a security guard was subject to the self-employment tax.
The rules when it comes to dealing with pension plans are very strict. If you or your company use the plan for personal or company purposes, the qualified status of the plan can be revoked. That's exactly what happened in Westchester Plastic Surgical Associates, P.C. (T.C. Memo. 1999-369). The corporation's only shareholder and the sole participant in the plan used the plan as a source of capital for his own benefit by taking loans from the plan. Caution. The results can be even more serious if the plan has employees. The entire plan will be disqualified. Repercussions from employees could include lawsuits.
Can the IRS issue a summons to get records from you and
third parties? They certainly can. In David Ramseyer, et
al. (99-2 USTC 50,931; U.S. District Court, No. Dist. Ohio,
East. Div.) the Court found that the IRS could enforce a summons
to obtain records from various sources. The Court held that the
IRS showed it met the good faith test by showing:
The general rule is that you can't take a deduction for benefits that extend beyond the tax year. In USFreightways Corporation (113 TC--, No. 23) the taxpayer deducted license and insurance expenses that were allocable to the following tax year. The Court denied the taxpayer a deduction. Instead, the portion that applied to the following year had to be capitalized and deducted in the subsequent year.
We've discussed how to calculate your basis in an S corporation and in a partnership (and LLC). If you don't understand the technical rules, you're not alone. In Thomas E. Hogan III and Sheila M. Hogan (T.C. Memo. 1999-365) the taxpayer could not prove he had any basis left with which to deduct losses incurred by his S corporation. However, the taxpayer avoided the negligence penalty because he relied on his accountant to prepare his returns. The Court even noted that computing basis is complicated.
In Internal Revenue News Release IR-INT-1999-13, the IRS announced that the Competent Authorities of Mexico and the U.S. reached a mutual agreement on the tax regime applicable to maquiladoras for years 2000 through 2002. The agreement provides legal certainty to current and potential investors in the maquila industry by establishing specific procedures to comply with tax provisions applicable in each country, and by eliminating potential double taxation. Both countries agreed that no permanent establishment shall be deemed to exist provided that maquiladoras comply with either of two options.
In Internal Revenue News Release IR-1999-89 the IRS reported that it expects to provide guidance next month on penalty relief for taxpayers who took necessary steps to prepare for the date change to the year 2000, but were unable to comply with the tax laws due to Y2K problems beyond their control. The guidance will provide key points about how taxpayers can request relief if the IRS assesses penalties for actions resulting from a Y2K-related computer failure. The taxpayer must make a good faith effort to become Y2K compliant. Two government websites have useful hints. Check the Y2K Help Center and President's Council on Year 2000.
In another hobby loss case (Raymond B. and Joan M. Marvin; T.C. Memo. 1999-362) the Tax Court disallowed all deductions related to the taxpayers' jade activity. The Court found the taxpayers maintained no books, had no business plan or financial projections. Moreover, they had only minimal income but took large deductions. And, while there's no rule that says you can't enjoy your business activities, the Court found that they had more emphasis on the recreational nature of the activity then was consistent with a business venture.
If you want to invest in a partnership or other venture, get expert advice from an expert before putting down your money. That's not only to protect yourself against losses, it's to secure a tax deduction if the venture goes sour. In Francis L. Rambacher (99-2 USTC 50,918; U.S. Court of Appeals, 6th Circuit) the taxpayer tried to claim losses associated with a tax shelter. The Court noted that the taxpayers relied only on the offering materials in making their investment decision. The Court found that their expectation that the venture would be profitable was not reasonable under the circumstances. The Court upheld the imposition of the negligence penalty.
If you're claiming a deduction, you need receipts, but you'll need more than a scrap of paper or a adding machine tape. The receipt should have a description of the merchandise purchased or the service provided, the date, and the name of the vendor. In Sandra L. McBrayer (T.C. Memo. 1999-360) the taxpayer had none of that. Worse, she could not recall any of the details of the purchase. If you get a receipt that's missing some of the information, add it yourself. For example, an adding machine tape with a date for $16.82. Write the items purchased and the name of the store or vendor. That should do for small items, particularly if your other records are good.
In the same case (Sandra L. McBrayer; T.C. Memo. 1999-360) the Tax Court disallowed a claimed theft loss. The taxpayer had no corroborating evidence to establish the items stolen or even the date of the theft. Theft losses are often difficult to substantiate, but you'll be on safer ground if you file a police report, file a claim with the airline, restaurant, hotel, etc., and file with your insurance company. You've also got to substantiate the fair market value of the items stolen. Original receipts will help; recent appraisals are better, but it's unlikely you'll have that. Around the house take pictures of items. Finally, you'll have to prove you didn't receive a recovery from the insurance company.
If you buy out a retiring shareholder and just purchase his stock, you get no deduction. The shareholder may have a capital gain or loss on the sale of his shares to the corporation. If you buy back his shares and make him sign a covenant not to compete, the covenant is amortizable. In John H. Miner and Holly K. Miner (T.C. Memo. 1999-358) the Court sided with the IRS in disallowing any deduction for a covenant. The Court found no evidence that a covenant existed, and, even if it did, it would have very little value. The Court found the shareholder's testimony that there was no intention to create a covenant was credible.
In the same case (John H. Miner and Holly K. Miner; T.C. Memo. 1999-358) the Court found that the S corporation adjusted its ending inventory down, ostensibly because of an accounting software problem. But the taxpayer did not explain how the adjustment was computed. In another issue in the same case, the Tax Court disallowed a deduction for the business use of a van. The Court noted the estimate of the expenses was not prepared until some 6 years after the expenses were incurred. Moreover, the estimate was not prepared from actual documentation but from memory.
Unless you can shift the burden of proof to the IRS by keeping good records and working with the IRS, the burden of proof is on you to show that the government is wrong in arriving at the amount of any additional tax due. In Michael L. Goers (T.C. Memo. 1999-354) the taxpayer failed to present any evidence in his favor. Thus, the Tax Court sided with the IRS. The Court also found him liable for tax penalties.
There are a number of factors the courts look at when trying a hobby loss case. In James M. Goforth and Brenda Goforth (T.C. Memo. 1999-356) the Court looked at the amount of time the taxpayer spent working on his cattle ranch. The Court noted that he spent very little time and used the ranch as a weekend retreat. The Court disallowed the losses.
Generally, if you take a distribution from a IRA prior to attaining age 59-1/2 you're subject to a 10% penalty on the taxable amount. (There are a number of exceptions.) In Luisa Deal (T.C. Memo. 1999-352) the taxpayer argued that she relied on bad advice from the IRS. The Court said that reliance on that advice did not excuse her from the penalty. The Court also dismissed her plea of financial hardship, noting there is no exception for such a situation.
In Dave Graf Daimler (T.C. Memo. 1999-353) the IRS asserted the taxpayers diverted funds from their business accounts to their personal accounts and failed to report substantial amounts of income. The Court found that the taxpayers were deemed to have admitted issues where they did not reply to IRS requests for information. The Court also found the taxpayers liable for the fraud penalty.
We've discussed this topic in prior issues. In fact, we had an in-depth article in our May 1, 1999 issue. But two recent cases are significant enough to revisit this topic.
Why the concern? In the case of a C (regular) corporation, the corporation wants to pay as high a salary as possible. That's because any amounts left in the corporation will be taxed twice if the assets are sold or if the amounts are paid out as dividends. Buy if the salaries are too high, the IRS can claim that salaries paid to officer/shareholders are excessive. In that case any excess payments can be reclassified by the IRS as a dividend. Dividends are not deductible by the corporation, but are income to the shareholders who receive them. That's the worst of both worlds. You may be able to win in Court, but just getting there is expensive, in both time and money. What about S corporations? To date, we know of no cases involving S corporations. However, that doesn't mean it can't happen. There are definitely some situations where the IRS could come out ahead by claiming unreasonable compensation was paid to officer/shareholders of an S corporation.
The first case (O.S.C. & Associates, Inc., d.b.a. Olympic Screen Crafts; 99-2 USTC U.S. Court of Appeals, 9th Circuit) was decided in the IRS' favor. The case was on appeal from the Tax Court and the Court of Appeals sided with the Tax Court. The facts are pretty simple. The majority shareholder (90% owner; his brother-in-law owned 10%) of the corporation started the business in 1970 with $180. He soon took on his brother-in-law as a shareholder and employee. By 1991 the business had over 200 employees and grossed over $13 million a year. Shortly after incorporating the business in 1982, the corporation adopted an incentive compensation plan. The plan was developed by the company's CPA and intended to compensate the two owners for their contributions to the company. Under the terms of the plan, the amount of incentive compensation was to be determined at the end of each fiscal year by first calculating a hypothetical gross margin. The gross margin was calculated by multiplying OSC's actual total sales by an adjusted industry gross margin ratio. The total incentive compensation pool consisted of the difference between OSC's actual gross margin and the hypothetical adjusted industry gross margin.
The plan provided that payments from the pool were to be made according to stock ownership. In addition to the above calculations, adjustments were to be made for inventory shortages, bad debts, inventory spoilage and excess production costs. As a practical matter, this formulation resulted in the corporation distributing nearly all (between 82% and 94%) of its net income as incentive payouts to the two shareholders. The CPA implemented the plan, but admitted he made errors that increased the distributions to the shareholders.
OSC never paid or declared a dividend, despite the fact that in 1988 and 1989, the years immediately following the adoption of the incentive plan, the CPA advised them to pay dividends. The president and majority shareholder refused. The president's antipathy to dividends was also reflected in a credit memorandum prepared by an officer of the company's bank in 1992 which noted the intent of the president was to reduce his overall taxes by taking a salary and bonus of $1.8 million in 1991.
At the Tax Court trial, OSC offered considerable evidence of the shareholder's extraordinary hard work and unique skills, and of the corporation's phenomenal growth and better-than-average performance due to their personal efforts. In many cases that would be enough to justify extremely high compensation.
But not here. The Tax Court found the plan allocations were
not made with a compensatory intent. It found the plan
was both designed and manipulated to direct the flow of corporate
earnings to the shareholders and to disguise the payments as
compensation.
The Court cited the following factors from an earlier case:
The Court noted that in order to be deductible, compensation must be (1) reasonable and (2) must in fact be purely for services. The Court went on to say that in most cases courts have focused on the reasonable test. If that's passed, they've allowed the deduction. In this case the IRS showed that, while the amounts may have been reasonable in amount, they were not intended to be compensation, but rather disguised dividends.
The Court noted the following factors influenced its
decision:
Not only did the taxpayer lose the case, because they attempted to disguise the payments, they were also assessed the negligence penalty.
The second case (Exacto Spring Corporation; 99-2 USTC; U.S. Court of Appeals, 7th Circuit) was decided in the taxpayer's favor. In fact, the Appeals Court reversed the Tax Court's decision.
Exacto Spring was a closely held corporation that paid its chief executive and principal owner $1.3 and $1.0 million for the two years at issue. The officer/shareholder was clearly the driving force behind the business. He acted as both a high qualified engineer, chief salesmen, and principal inventor. Nonetheless, the Tax Court ruled that the maximum reasonable salaries were $900,000 and $700,000. In reaching its conclusion, the Tax Court looked at the 7 factors often used to determine reasonable compensation. The Court found the 7 factors either in favor of the taxpayer or neutral, yet disallowed some of the salary.
The Appeals Court throw out the 7 factor approach, finding several faults with the method. Rather, the Court looked at the return that an investor would have received by investing in the company and whether or not that investor would be satisfied even if the officer/shareholder received the salary claimed by the taxpayer. The IRS' expert testified that a reasonable return, adjusted for the risk of Exacto's business, would be 13%. The Court found that the actual return to the investors was 20%. Given that return, the Court reasoned that the shareholders should be very happy, despite the president's high salary. The Court allowed the corporation's claimed salary deduction in full.
There are two cautions here. First, the income of the corporation must be "earned", not a windfall. For example, the company has consistently reported profits of about $100,000 a year. In 2000 it receives $2,000,000 as damages in an antitrust suit. You can't count that as earned.
Second, as in the first case, you've got to be careful of disguised dividends. In this case there were two minority shareholders, each with a 20% interest, who approved of the compensation. Board voting by minority shareholders will go a long way in bolstering your case. Basically, you've got to show the amount paid was intended as salary and not a disguised dividend. The best way of doing so is to set up a compensation and bonus plan well ahead of time.
Each situation is different. Making a mistake here can be very expensive. Consult a tax professional for advice and then follow through.
When is a Dividend not a Dividend?
Earnings and profits (E&P) is an arcane topic that even tax professionals often fear to tackle. It's the tax substitute for the retained earnings used in financial accounting. The theory is the same. A corporation starts off on day 1 with retained earnings of zero. That's increased by the net income of the corporation and decreased by losses and distributions (dividends) to shareholders. Earnings and profits are similar, but some items are used in the computation differently. A corporation's retained earnings and its earnings and profits often track each other closely.
Why the concern over an obscure theory that even tax law and the IRS hasn't officially defined? Because the number can have significant tax consequences. For example, a dividend from a regular corporation is taxable to an individual shareholder at rates up to 39.6%. But, in order to be a dividend for tax purposes, the amount must be paid out of the corporation's earnings and profits (E&P). If there is insufficient E&P available, the distribution is part dividend and part return of capital. Beyond that, you could have a capital gain.
(Technically, earnings and profits are the income for one year. The total E&P from the inception of the corporation is called the accumulated E&P. In practice, the term E&P is often used in place of accumulated E&P.)
Example--Madison Inc. was started by Fred Flood with a $5,000 investment. Over the years it has accumulated E&P of $9,000. In 2000, in anticipation of a large influx of cash from an outside investor, Madison declares a $25,000 dividend to Fred. For tax purposes, the first $9,000 (equal to the amount of the E&P) is a dividend, taxable at ordinary income rates. The next $5,000 (Fred's investment) is a return of capital. It's not taxable to Fred, but it does reduce his basis in the corporation to zero. But Fred received another $11,000 in distributions. Since Fred's basis in Madison is now zero, that additional amount is a long-term capital gain, taxable at a 20% rate.
There's another problem. If you have a nontaxable dividend, you'll have to file a special form (Form 5452, Corporate Report of Nondividend Distributions) with the IRS National Office. They'll review the form. That's got to increase your audit chances. And your accountant or tax adviser will have to compute your E&P. If it's never been done before, he'll have to go over all your old tax returns back to the year you started in business or 1913, whichever is earlier. That's an expense you don't want to deal with.
On the other hand, if you're audited and the IRS disallows car expenses, travel and entertainment, compensation, etc. of employee/shareholders, amounts that are not out of E&P aren't dividends.
What about S corporations? They generally don't have this problem, unless the entity was once a regular corporation. If that's the case, the E&P follows the corporation. That may or may not be a problem. Ordering rules apply to distributions paid by the corporation. The first distributions are deemed to come out of the accumulated adjustment account (AAA) of the S corporation. Once that's exhausted, additional distributions are deemed to be out of the E&P of the corporation.
Example--Madison Inc. was incorporated in 1994. At the end of 1997 it had E&P of $100,000. On January 1, 1998 Madison switched to S corporation status. At the end of 1999 Madison had AAA of $10,000 and paid distributions of $30,000 to its shareholder. The first $10,000 of the distribution would be nontaxable. The remaining $20,000 would be a taxable dividend, paid out of the E&P generated while Madison was a regular corporation.
There are several other traps that can befall an S
corporation that has accumulated E&P. They include:
Caution. There are other traps and the rules here are very complex. You'll need professional guidance.
Tax Tip--There's an election you can make to avoid many of these problems. In essence, you can get rid of your accumulated E&P by taking a dividend. Going back to the example above, Madison Inc. could have elected to have all the distribution be a dividend out of the E&P of the regular corporation than part S corporation distribution and part regular corporation dividend. While the dividend would be taxable, it can make sense if timed properly.
How do you calculate a corporation's E&P? There are a number of items that must be taken into account. And even professionals disagree on some of the adjustments. However, the items below are the ones you're most likely to encounter. In our Forms section we've included a more detailed list.
While some of the adjustments may not make much sense, others are designed to take into account economic income and expenses, rather than taxable income and deductions. For example, federal income taxes are not deductible in computing your taxable income, but they do reduce earnings and profits. Likewise, only 50% of meals and entertainment expenses are deductible for income tax purposes, but the full 100% of those expenses reduce E&P.
The first step is to start with your taxable income. Then add the following:
Tax-exempt income. Basically any income that is not taxable. The two most frequently encountered items would probably be municipal bond interest and life insurance proceeds on officers to the extent they exceed the cash surrender value of the policy.
80% of current year's Sec. 179 deductions. If you elected to expense any equipment purchases during the year, for E&P purposes you must spread the amount over 5 years. Thus, in the first year you've got to add back 80% of the amount. You'll deduct the remaining amounts over the next 4 years, 20% a year.
Example--You purchase several new computers for $10,000 in 2000. For income tax purposes you deducted the entire $10,000. For E&P purposes you can only deduct $2,000 in 2000; $2,000 in 2001, etc. Thus, to adjust taxable income to E&P you've got to add back 80% in 2000.
Accelerated depreciation. This one is similar to the Section 179 expense. For E&P purposes you can only deduct depreciation using the straight-line method and the alternative MACRS lives. Thus, while office furniture would normally be depreciated using accelerated depreciation over 7 years, you've got to use the straight-line method over 10 years. Different rules apply to property placed in service before 1987. To adjust taxable income to E&P add back all depreciation deducted for income tax purposes and then recompute depreciation using the rules just discussed.
Net operating losses. Not deductible in computing E&P. Add them back. They reduce E&P in the year they occur.
Installment sales. You can't use the installment method for computing E&P. Thus, if you used the installment method for computing taxable income, you must include the entire gain in the year of the sale. You do this by adding the deferred gains in the year of sale to taxable income.
Carryovers. Since many carryovers (such as for charitable contributions) are deductible immediately, you have to add back any carryovers that you deducted in the current year. See Charitable contributions, below.
The next step is to subtract the following from taxable income:
Federal income taxes. This is the big one. For E&P purposes you can deduct current year income taxes.
Depreciation. Subtract depreciation for the year using the method for E&P computation discussed above.
Meals and entertainment. To arrive at taxable income, you've already subtracted 50% of meals and entertainment expenses. To get to E&P subtract the other 50%. You may also be able to deduct disallowed expenses that do not meet the substantiation requirement.
Premiums on certain life insurance. You can deduct premiums on life insurance policies if the corporation is the beneficiary. That applies to term life and premiums on keyman whole life policies to the extent they exceed the increase in the cash surrender value.
Excess charitable contributions. For income tax purposes your deduction for charitable contributions in any one year is limited to 10% of your taxable income. For E&P purposes, that limitation doesn't apply. Thus, deduct any contributions in excess of the 10% limit.
Expenses to earn tax-exempt income. Normally, you can't deduct expenses that you incur to generate income that's not taxed. However, for E&P purposes you can. Thus, you can deduct interest incurred to purchase tax-exempt municipal bonds.
Capital losses. A corporation can't deduct capital losses directly. They can only be used to offset capital gains. For E&P purposes you can deduct in the year incurred the excess of capital losses over capital gains. Note. Net capital losses can be carried forward. This is another carryforward item that must be added back (see above).
Business gifts. The amount of business gifts that exceed the $25 limit are deductible for E&P purposes.
Fines and penalties. These should be deductible toward E&P, but the IRS may object.
Dividends and distributions. Dividends and other distributions to shareholders reduce E&P. Distributions of property that has not appreciated reduce E&P by the adjusted basis of the property. Distributions of appreciated property reduce E&P by the fair market value of the property.
This is a very complex topic. Even tax scholars disagree on some of the rules. The worksheet in our Forms section, E&P Computation Worksheet includes the most frequently encountered adjustments. There may be ones that are not included on the form.
For additional information see IRC Sec. 312 and Rev. Procs. 75-17, 85-1, 86-1, 88-1, 87-1, and 98-1.
Extended Out-of-Town Assignment Deductible
When you're on business away from your home and deducting travel expenses, the law makes a distinction between temporary and indefinite. If your assignment at the other location is temporary, you can deduct living expenses (room, meals, etc.) there. If that assignment is indefinite, you can't. The law considers the away-from-home location your new tax home. Thus, you're not away from home and there are no travel expenses. When does a temporary assignment become indefinite? If the employment at the new location is expected to last more than one year, it's considered indefinite, whether or not the assignment actually lasts more than a year. Or, the assignment is indefinite if it lasts one year or more, regardless of how long it was expected to last. When considering the time away from home, only time at a single location counts.
Unfortunately, not all taxpayers will fit into this neat definition. That's what happened in the case of Thomas J. Mitchell, et ux. (T.C. Memo. 1999-283). The taxpayer lived in Orland Park, Illinois. While there he began to consult as an independent contractor for a printing company in New York, NY. He worked out of his home, using a room that he had set up as his office. The room had a dedicated phone line, a fax machine, an answering machine, a desk, and file cabinets.
A magazine publisher based in Los Angeles hired a publisher, and retained the taxpayer for 4 months primarily to advise the new publisher and the company on its printing process. After the 4 months were over, the company retained the taxpayer for another short period of time to advise the publisher on a new concept for its magazine. The publisher was abruptly fired the following year and the company hired a new publisher. She had no experience as a magazine publisher, and the company retained the taxpayer on an as needed basis to advise her for a period of time of not more than 1 year. The taxpayer advised the publisher and the company on printing. From his home he also advised the company on circulation. The taxpayer worked in California approximately 130 days in 1992, 42 of which were spent in the company's print shop and the remaining days were spent in the company's offices 70 miles away.
In 1993 the company retained the taxpayer to perform a marketing study from his home in Orland Park and to continue as an adviser on an as needed basis. The taxpayer continued to advise the company in California and spent about 130 days there in 1993. The taxpayer expected his engagement to stop after the marketing study was completed. However, in early 1994 the publisher was diagnosed with cancer. The taxpayer substituted for the publisher in meetings in California and advised the company from his home in Orland Park. In 1994 he spent 123 days at the company headquarters in California and 32 days at the nearby printing plant. At the end of 1994 the taxpayer and the company agreed that his work in California was complete. However in early 1995 the taxpayer was again called on to help the company in California. In 1995 he spent 113 days in California, 21 days at a new plant in Oklahoma, and 90 days working for the company while in Orland Park.
During all of the years in question, the taxpayer was registered to vote in Illinois, registered his car there and maintained his only checking account in Illinois. His only connection with California was that he performed services there. During the years at issue, the company did not restrict the taxpayer from providing consulting services to other companies, and it did not give him an office in California. Moreover, the taxpayer did offer his consulting services to other prospective clients during those years.
The IRS claimed that, because of the extended time he spent in California, that became his tax home and any living expenses incurred there were not deductible.
The Court held that the taxpayer's tax home during 1994 and 1995 was in Orland Park, Illinois. He lived in Orland Park during those years, and his consulting practice was based in that city. His travel to California was dictated by the exigencies of his work for his client and not from his personal choice. He spent more time working during each of the subject years in Orland Park than he did at either location in California, or, for that matter, in California as a whole. His only connection to California was the fact that he provided services there on an as needed basis, and he was able to, and did, actively seek other engagements that he would perform from his office in Orland Park.
Moreover, the Court noted that the IRS claimed correctly that his work in California occurred in at least 5 different years. But the Court found that the taxpayer did not exceed the 1-year period. The taxpayer's work for the company was on again and off again throughout the relevant years, with the company continually renewing his engagement because of unexpected happenings. His travel to the company's offices was incident to the fact that his employment was based in Orland Park and that he was providing his consulting services out of Orland Park. Merely because an independent contractor may return to the same general location in more than 1 year does not mean the contractor is employed in that general location on an indefinite basis. This is especially true here where the taxpayer is not restricted to working solely for the company and actually sought other engagements.
What's the message here? First, if you're an independent contractor you should be careful not to spend too much time in a single, out-of-town location. Make sure you can show that your tax home is really the area where you live. Try to do as much work out of your home base as possible. You'll be on much safer ground if you have more than one client. If you have only one, try to show that you're actively looking for additional clients and that your arrangement with the client isn't on an exclusive basis. The taxpayer here had the facts on his side. That is, the assignment was extended several times because of unforeseen circumstances. You may not be so lucky.
Second, you may run into a problem if you're an employee or an employee/shareholder. For example, you live in Massachusetts where your company's principal offices have been for years. You open a new factory in South Carolina and, between being on site during construction and startup, you spend over a year virtually full time at the new site. The IRS can claim your tax home is South Carolina and your living expenses there would not be deductible. On the other hand, if you spent alternate weeks in South Carolina and Massachusetts, the employment in South Carolina should be temporary.
You could have a problem even if you're at the out-of-town location less than a year. The IRS could claim a shorter period is indefinite if it looks like you've abandoned your former residence.
This can be a tricky area and there could be a lot of money at stake. Talk to your tax adviser and let him evaluate the situation. But be sure to give him all the facts; that's critical.
The IRS recently issued some interesting statistics on last year's tax season. Here are some of the findings.
Previously Reported In Daily Update
Freight, sales taxes, installation, etc. . . . If such items are associated with the cost of an asset that must be capitalized, you can't deduct the expense. Instead, you've got to capitalize it. You can recover the outlay through depreciation or the Sec. 179 expense option. For example, you purchase a machine for $5,000. The final price includes a shipping charge of $500 and sales tax of $250. In addition, you hire a local firm to install the machine for $300. The final price is $6,050. That's your basis for depreciation. Unless you can use the Section 179 expense option, none of the cost is currently deductible. What if you use your employees to install the equipment? You should calculate the labor costs by multiplying the hours it took times their total cost per hour. That includes their base salary, fringes, etc. That amount has to be capitalized and added to the cost of the equipment.
Penalties and fines not deductible . . . Traffic tickets, speeding tickets, etc. That even includes parking tickets. Generally, if the fine or penalty is paid for the violation of a law, no deduction is allowed. Weigh the consequences of putting money in the meter versus paying a nondeductible fine that could exceed $100 in many cities.
Back property taxes may not be deductible . . . You buy a home, commercial property, etc. with delinquent back taxes (and other charges such as interest, etc.) at a foreclosure sale. Can you deduct all the taxes? No. Your deduction is limited to the portion of the taxes attributable to the time since you owned the property. Those prior accumulated taxes are part of the purchase price. If the property includes a building, a portion of the taxes, interest, etc. should be allocated to the building for which you can claim depreciation.
Saving for college? . . . If you're putting money away for your child's education, a Roth is one option. While the earnings accumulated by the Roth will be taxable if you withdraw the funds before reaching age 59-1/2, the annual contributions are not subject to taxation. Thus, if you and your spouse have been contributing the maximum for 10 years, you'll have made a total of $40,000 in contributions. That sum can be withdrawn tax free. The earnings left in the account can be withdrawn tax free after reaching age 59-1/2.
Got insurance? . . . If you're a business owner you should check your business insurance policies to see if you're covered in case an employee sues you for wrongful termination. There have been more suits lately and the settlements have gotten larger. Now a new twist. Recently, former employees have been suing not just for back wages but for the loss of profits on stock options. For example, you agree to give an employee stock options, but before the employee receives them, you fire him. Or, he has the options, but can't exercise them because he was terminated. In one case a former employee was suing for $300,000 in lost wages and $20 million in lost option profits. High tech companies are especially vulnerable. Check your policy and then talk to your attorney.
Postage costs . . . Bulk mail, presorted rates, etc. change from time to time. Check the post office for the latest rates, discounts, size requirements, etc. Talk to the postmaster or assistant postmaster. They know the rules, and, for the most part, are more than willing to help. The postal service is much more customer oriented than in the past. You can also check prices and some rules at their web site www.usps.gov.
IRS Publications updated . . . The IRS has released some new and updated other publications. The following are now available:
Don't overshop . . . Some business owners overshop when it comes to looking for a loan, venture capital, buying a business, or doing any number of deals. Word often gets around and if you overshop you run the risk that you won't get any takers. For example, you're looking for venture capital. You approach a number of sources, but are turned down because they think the deal is too much in your favor. Word gets out and soon you're not even able to get an interview. That could be true even if you revise the deal and lower your sights. There's no easy answer here, but if you don't understand the market, get expert advice upfront. Getting 90% or even 80% of what you want is usually better than nothing. On the other hand, if you're willing to risk losing everything, holding out may make sense. For example, you're looking at acquiring a product line, but it's not the only way to grow. If there are no negative consequences, (e.g., a competitor picking up the line), you can bid low. Talk to your accountant, banker, etc. They can often provide you with sound advice.
S corporations and passive income . . . Passive income (e.g., rental income) received by an S corporation can result in the termination of the S corporation election and a special tax if the corporation was once a C corporation and has accumulated earnings and profits. That's why knowing the rules here can be critical. Not all rental income is passive when it comes to these rules. It depends on how much services are provided with the rental. For example, you own a warehouse which you rent under a net lease. That's clearly passive income when it comes to these rules. On the other hand, if you own a shopping center and along with renting space you take care of garbage, snowplowing, provide co-operative marketing for the center through promotions, etc. in addition to the regular maintenance, that's more than a passive rental. The case for a nonpassive activity becomes stronger if you own several rental properties. The result here depends importantly on the facts and circumstances. Check with your accountant on the details.
IRS Publications updated . . . The IRS has released some new and updated other publications. The following are now available:
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