Small Business Taxes & Management

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

Tenancy in Common or Joint Tenancy?--There are a number of tax and legal differences.

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

News On The Tax Front

Previously Reported In Daily Update

If the IRS believes that the assessment or collection of tax will be jeopardized by delay (e.g., the taxpayer will transfer funds outside the country), the IRS may immediately assess the deficiency and make notice and demand for payment. The action is called a jeopardy assessment. In George G. Green (121 TC--, No. 18) the Court rejected the taxpayer's motion for a judicial review of the jeopardy assessment and levy. The Court noted that Section 7429(b)(1) expressly provides that the proceeding for judicial review in the Tax Court or the District Court, as the case may be, must be commenced within 90 days after the earlier of the day that the IRS notifies the taxpayer of the Service's determination or the 16th day after the request for review under Section 7429(a)(2) was made. Since the earlier date was the 16th day after the taxpayer's request, that was the starting date for the filing deadline. Thus, the taxpayer's filing was late.

The IRS can issue a third-party recordkeeper summons to a bank, brokerage house, or other entity to obtain records that might help the Service in assessing your tax liability. The IRS must provide notice to the taxpayer before issuing the summons so that the taxpayer may petition the court to quash it. In Thomas E. Tilley (2003-1 USTC 50,731; U.S. District Court, West. Dist. N.C., Statesville Div.) the taxpayer did petition the Court, but did so too late. The Court noted that the 20-day limitations period in which to file a petition starts the day the IRS mails the notice. The taxpayer claimed that timely mailing is timely filing. While that's true for filing a tax return and certain other filings, it's not true here. The taxpayer's petition was received just after the deadline. Check the rules. In this case the taxpayer should have used other means to file the petition.

The IRS has published final regulations in the following areas:

T.D. 9110 Section 42 low-income housing credit in accordance with Community Renewal Tax Relief Act of 2000
T.D. 9107 Capitalization of amounts paid to acquire or create intangible assets
T.D. 9104 Definition of qualified research under Sec. 41(d) for increasing research activities credit
T.D. 9102 Definition of income under Sec. 643(b) necessary to reflect changes in definition of trust accounting income under state laws

The IRS can get a court order to enforce a summons to produce documents. In Robert V. Plath and Beverly Plath (2003-1 USTC 50,729; U.S. District Court, So. Dist. Fla.) the IRS initially gave the taxpayers Information Document Requests for various documents including copies of statements for foreign bank accounts. The taxpayers did not submit the information. The IRS then issued two summonses. When the taxpayers did not attend an IRS meeting, the IRS filed a petition to enforce the summonses. Subsequently, the Court issued an Order to Show Cause. The taxpayer argued he was not in possession of the requested records. The Court found the IRS established evidence that the taxpayer violated the Court's Order enforcing the petition and, the burden having shifted to the taxpayer, he did not adequately demonstrate that he has taken all reasonable efforts to comply with the summons. The Court found the taxpayer in civil contempt and gave him 30 days to comply with the summons. The Court furthered order that if he did not comply, that he should be confined at a corrections facility until he does comply.

The Tax Court rules provide that either party may move for summary judgment upon all or any part of the legal issues in controversy. Summary judgment is intended to expedite litigation and avoid unnecessary and expensive trials. Summary judgment is appropriate "if the pleadings, answers to interrogatories, depositions, admissions, and any other acceptable materials, together with the affidavits, if any, show that there is no genuine issue as to any material fact and that a decision may be rendered as a matter of law." The moving party bears the burden of proving that there is no genuine issue of material fact, and factual inferences will be read in a manner most favorable to the party opposing summary judgment. Summary judgment is appropriate where the facts deemed admitted (pursuant to Tax Court Rule 90(c)) support a finding that there is no genuine issue as to any material fact. In short, if the facts are not in dispute, the Court may grant summary judgment. In John R. Toney (T.C. Memo. 2003-333) the Court noted that the taxpayer had entered into a plea agreement in his criminal case, admitting he owed the unpaid taxes. The taxpayer did not respond to the requests for admission and the Court found that each matter of which the IRS requested admission was deemed admitted. In addition, the taxpayer presented no specific facts indicating that a portion of the underpayment is not attributable to fraud. The taxpayer presented no documents or testimony concerning nonfraudulent actions taken as to any portion of the underpayment. Consequently, the Tax Court upheld the fraud penalty.

The IRS has published revised procedures for issuing letter rulings, determination letters, etc. The revised procedures are contained in the following revenue procedures:

Rev. Proc. 2004-1, IRB 2004-1 for letter rulings, determination letters, and information letters
Rev. Proc. 2004-2, IRB 2004-1 for technical advice to appeals office district directors and chiefs
Rev. Proc. 2004-3, IRB 2004-1 contains an updated list of those areas in which the IRS will not issue advance rulings or determination letters
Rev. Proc. 2004-6, IRB 2004-1 contains revised procedures for issuing determination letters on the qualified status of employee plans under Sections 401, 403(a), 409, and 4975(e)(7)
Rev. Proc. 2004-8, IRB 2004-1 contains guidance for complying with the IRS user fee program for tax-exempt and government entities.

The courts are generally careful in siding with the IRS when it comes to fraud. The IRS must not only show an understatement of income, but must also prove fraudulent intent. The burden is met if it is shown that petitioner intended to evade taxes known to be owing by conduct intended to conceal, mislead, or otherwise prevent the collection of such taxes. In Kevin J. Morse (T.C. Memo. 2003-332) the Court found the taxpayer fraudulently underreported his income for four years. The Court noted that the taxpayer, a farmer, stipulated that he omitted grain sale receipts of $75,799, $39,900, $24,481, and $68,713 during the four years at issue. The Court found the following badges of fraud were present: (1) Substantially understating income for several years, (2) providing incomplete or misleading information to his tax preparer, and (3) being convicted of filing false returns under section 7206(1) and found the taxpayer liable for the fraud penalty. The statute of limitations had not expired because the IRS established that the underpayment was due to fraud.

In limited situations, taxpayers filing joint Federal income tax returns may be relieved from joint and several liability pursuant to section 6015. Known as innocent spouse relief, the taxpayer must satisfy a number of requirements. In Brenda Wallace (T.C. Memo. 2003-330) the Court denied a surviving spouse innocent spouse relief. The Court noted that tax liability was solely the result of her income and no understatement could be attributed to her deceased husband.

The IRS announced it is aware of a type of transaction in which the taxpayer claims a loss upon the assignment of a Section 1256 contract to a charity but fails to report the recognition of gain when the taxpayer's obligation under an offsetting non-section 1256 contract terminates. The IRS is alerting taxpayers that these transactions are tax avoidance transactions and are considered listed transactions for purposes of Reg. Sec. 1.6011-4(b)(2). See Notice 2003-81 (IRB 2003-51) for complete details.

The IRS has announced (IR-2004-2) a new page at the IRS web site--1040 Central. 1040 Central and other enhanced electronic services should make the agency's web site an even easier-to-use source of information. Tens of millions of taxpayers will begin receiving their tax packages for the 2004 tax season this week. 1040 Central has links to information on the Earned Income Tax Credit, changes for 2003 returns, the Advance Child Tax Credit, etc.

The auditors get audited. In Internal Revenue News Release IR-2004-1 the Service reported that it is taking new steps to ensure that agency employees strictly meet and follow their tax filing and payment requirements. Earlier this year, IRS employees raised questions about tax returns being submitted by other agency employees involving Schedule C returns. In turn, the Treasury Inspector General for Tax Administration was alerted. About half of the 25 employees identified had tax compliance issues following an investigation of their Schedule C filings. Several employees in the inquiry have already lost their jobs. The IRS has identified approximately 800 employees for further review, and they face an examination on Schedule C issues, most of which are already underway.

Personal living expenses are not deductible. But health insurance and medical expenses paid for employees, business related meals and entertainment, and meals and lodging for employees who are required to remain on the premises while at work may be deductible. The IRS closely scrutinizes any such deductions. In Ricky Schmidt and Suzetta J. Schmidt, Hillside Dairy, Inc. (T.C. Memo. 2003-325) the corporation had a medical reimbursement plan for their closely held corporation. The plan provided for the payment of all medical expenses that would be deductible on Form 1040 to the extent not compensated by insurance. Under the plan, each participant was entitled to a maximum reimbursement of $10,000 per year. The corporation also paid the premiums on the employee/shareholder's health insurance policy. The Court sided with the taxpayers on this issue. Noting that the law requires first, that the benefits be received under a "plan", and second, that the plan be "for employees", rather than for some other class of persons such as shareholders and their relatives. The Court decided the corporation's plan met both requirements. The corporation also paid the meals and lodging expenses of the employees. The corporation operated a dairy farm and adopted a corporate resolution that the employees shall be required to live at the worksite of the corporation. The Court sided with the IRS here denying a deduction. The taxpayer might have won this issue too, were it not for the fact that the taxpayer farmed the land as a tenant, not an employee of the corporation. (See also Ronald D. Weeldreyer, Dryer Farms, Inc. (T.C. Memo. 2003-324); Robert W. Tschetter, Wolf Creek Farm, Inc. (T.C. Memo. 2003-326) and Waterfall Farms, Inc. (T.C. Memo. 2003-327))

The IRS has issued guidance (Notice 2004-8; IRB 2004-4) designed to shut down abuses involving indirect contributions to Roth IRAs. The notice indicates that these abuses satisfy the list-keeping and registration requirements for tax shelter arrangements that are "listed transactions." The guidance addresses situations in which value is shifted into an individual's Roth IRA through transactions involving entities owned by the individual. For example, a business owned by the individual could sell its receivables for less than fair value to a shell corporation owned by the individual's Roth IRA. This scheme artificially shifts taxable income away from the individual's business into the shelter of the Roth IRA structure. "In effect, this is a disguised contribution to the Roth IRA and the notice makes clear that it will be treated as such."

A deadline is a deadline. In Wallace and Donnetta Duncan, et. al. (121 TC--, No. 17) the taxpayers and the IRS agreed to voluntary binding arbitration (Tax Court Rule 124) with respect to the fair market value of numerous West Virginia natural gas wells. The agreement contained strict deadlines on the submission of information for the arbitrator to make a decision. The IRS agreed to extend the deadline, but indicated it would not do so again. The Court sided with the IRS in disallowing an additional extension.

Income from a business is taxable to the person who controls the business. In David A. Demetree (T.C. Memo. 2003-323) the taxpayer closed his real estate property management firm to deal with a divorce and later to take care of his 5 children. His father operated a commercial property management firm as a sole proprietorship. In later years the taxpayer signed, pursuant to a power of attorney, his father's name on business checks and deposits. After his father's death, the taxpayer began managing the properties. A disgruntled employee alleged to the IRS that the taxpayer had taken funds from the business and failed to report the income. The IRS initiated a criminal investigation. The Court found that the income from the business belonged to his father, who actively managed and controlled the business, not to the taxpayer. The Court found that the testimony of the former employee was not credible. (The taxpayer probably didn't help his position with the IRS because he failed to file returns for several years and filed late for a number of years.

The Justice Department has announced that it plans to file suit to bar Texas resident Harry Anderson from promoting an alleged sham tax scheme. The suit alleges that Anderson claims that a home based business can be used to deduct personal expenses such as travel, meals, cars, medical expenses, etc. The "Tax Toolbox" has been sold through seminars and over the internet.

The IRS has issued proposed, temporary, and final regulations (T.D. 9105; REG-126459-03) to clarify which changes in depreciation are changes in method of accounting. These regulations and a revenue procedure (Rev. Proc. 2004-11; IRB 2004-3) will provide certainty for taxpayers and reduce controversy. In recent years, uncertainty has existed regarding whether a change in the period of recovery of depreciable property was a change in method of accounting. The regulations provide that a change in the period of recovery specifically assigned by the Code, the regulations, or other published guidance is a change in method of accounting. The regulations also provide, however, that a change in the useful life of depreciable property is not a change in method of accounting if the useful life of the property is not specifically assigned by the Code, the regulations, or other published guidance. In addition, the regulations provide that a change in depreciation method or convention is a change in method of accounting. Previously, the IRS issued guidance to permit a taxpayer who had claimed less than the depreciation allowable for its property to change its method of determining depreciation for the property. This guidance has enabled many taxpayers who had claimed less than the depreciation allowable to claim the full depreciation allowable. The IRS issued a revenue procedure to permit a taxpayer to make this change after the disposition of the depreciable property. As a result, a taxpayer who has claimed less than the depreciation allowable for its property will no longer risk permanently losing an allowable depreciation deduction.

The IRS has issued final regulations (T.D. 9102) amending the definition of income under Section 643. These regulations also clarify the circumstances under which capital gains are included in the distributable net income (DNI) of an estate or trust. Section 643(b) of the Code defines income for purposes of numerous federal tax provisions, including determining qualification for the estate and gift tax marital deduction, and computing required distributions from pooled income funds and certain charitable remainder trusts. With certain exceptions, this definition generally relies on the definition of trust accounting income under state law and the trust agreement or will. Many states have now changed their definitions of income to permit trusts and estates to adopt a more profitable method of investing their funds, and to promote more equitable and impartial treatment of those with interests in the income or principal of those entities.

Tenancy in Common or Joint Tenancy?

A number of readers have asked about this. Just a different name for the same thing? Far from it. If you and another party--your spouse, child, relative, friend, business partner, etc. want to co-own property, both forms can be used. But the legal consequences are very different. If you and a friend own property as joint tenants, the property automatically passes to the survivor on the death of the other party. Good news? You don't need a will. Bad news? A will won't change the outcome. And, no matter how many co-owners are involved, it's assumed that each has an equal share. Thus, if Fred, Sue and Dick purchase a rental as joint tenants, each will have a 1/3 share. Finally, in the case of jointly owned property, no owner can sell his or her share without the other parties' consent.

On the other hand, if the property is owned as tenants in common, the ownership shares can be different and each party is considered to own his or her share and can dispose of it as they wish. For example, if Fred puts up 20% of the purchase price, Sue puts up 50% and Dick puts up 30%, that's what their ownership interests will be--20%, 50%, and 30%. Each party can leave his or her shares to any beneficiary on death or sell their interest to any other party without the consent of the other owners. Each party can also encumber (borrow on) his or her interest in the property (the rule here varies by state). All parties should keep a record of the expenditures they pay, paying attention to the type of expenditure. That is, whether the funds were used for general upkeep (maintenance, property taxes, etc.) or to pay the mortgage or for capital improvements. Keep in mind that each owner is jointly and severally liable for the mortgage. That means, should the other parties not pay, you can be responsible for the entire amount. What happens if you haven't chosen a form of ownership after purchasing property with another party? In some states, ownership as tenants in common is assumed.

There are several other ways to jointly own property.

The first is called tenancy by the entirety with right of survivorship. It's similar to joint tenancy (the surviving spouse automatically inherits the property on the death of the other spouse), but is only available to married couples, and only about half the states allow it. Some married couples automatically choose this option. But that's not always the best approach.

The second is by setting up a partnership. This is more expensive. You'll have to draft a partnership agreement, file papers with your state, file federal and state tax returns for the partnership, set up a bank account, etc. But there are a number of advantages here. First, your partnership interests can be very different. For example, Fred puts up 30% of the funds to buy the property and Dick puts up 70%. But Fred agrees to manage the property and cover 50% of the maintenance expenses. Fred could have a 30% capital interest (e.g., he gets 30% of the proceeds on the sale), but is entitled to 50% of the profits and losses. In situations like this, a partnership makes particular sense. Second, should Fred decide to leave, he can simply sell his partnership interest without selling the underlying property. That's important if more than one property is involved. (Selling a partnership interest isn't all that simple, but it's easier than dealing with joint ownership.) Because of the cost of dealing with a partnership, it probably doesn't make sense for a vacation home that's not rented for profit, particularly if the parties are relatives. The big disadvantage of a partnership is that the partners are jointly and severally liable for the debts of the partnership. (A limited partnership avoids that problem, but is more complicated. You can also avoid the problem by organizing as an LLC.)

An LLC (limited liability company) is similar to a partnership in that it exists as a separate entity, files tax returns, and is generally taxed as a partnership. The big difference is that LLC owners are generally not responsible for the liabilities of the entity.

You might consider setting up a trust. This approach is very popular way to hold real estate in some states, but it's often not as flexible. It can be a good way of holding real estate for appreciation, or a vacation home or simple rental property.

A S corporation is sometimes used as an alternative to a partnership, but it's not the most attractive choice. There is no such thing as separate capital and profits interests. The big advantage is the limited liability for shareholders and ease of transferring ownership (you can simply sell your stock).

A C corporation can be used for holding and renting property, but there are a number of disadvantages including the double taxation of profits and gains, the inability to currently use losses, etc. That generally makes it a poor choice.

What's the best method? There's no one answer here. Certainly if you're looking at multiple properties, particularly if this is a business venture, a partnership or LLC is an attractive option. The set-up and annual costs are spread over several properties. That's especially true if there's no easy division of profits and losses and sales proceeds, or if one party is providing more or less labor and more or less capital. A trust can be a way of relatives holding a family vacation home or rental property. Joint ownership generally only makes sense between close relatives. For example, a mother and daughter holding family property.

No matter what form you select, you may not be able to avoid problems without a side agreement if there's a disgruntled co-owner. Even in an S corporation, a shareholder who owns 20% of the stock may be able to stonewall actions, or transfer shares to someone you don't want as a shareholder. The only solution is a side agreement restricting the sale of shares, a partnership interest, etc. Consider a buy-sell agreement where any co-owner wanting to get out has to sell to the other co-owners at the appraised, book, or other prior agreed-on approach. In the case of joint ownership, consider a legal agreement on how and when to dissolve the co-ownership.

Get good legal advice before committing. It's a small price to pay to avoid a costly legal battle in the future.

In Brief:

Previously Reported In Daily Update

How long must you keep employer copies of W-2s? . . . The retention period for many documents is only three years from the date of filing your tax return. (You've got to keep documentation on all capital assets for three years from the date of filing the tax return for the year the asset was sold.) But Copy D of W-2s given to your employees and Form W-3 should be kept for 4 years. And, check the rules in your state. A number of states require longer retention periods for payroll records.

False W-2s . . . If you fail to provide an employee with a correct W-2 and cannot show reasonable cause, you may be liable for a $50 per statement penalty. There's generally no penalty for an inconsequential error, but a dollar amount or a significant item in the payee's address, the taxpayer's identification number, or the payee's surname is never considered inconsequential. If you willfully file a fraudulent Form W-2 for payments you claim you made to another person, that person may be able to sue you for damages. You may have to pay $5,000 or more.

Fringe benefits and W-2s . . . Fringe benefits that are not taxable income (e.g., employer paid health insurance (but not for 2% or more S corporation shareholders), qualified educational assistance, etc.) aren't reported on the employee's W-2. The same is true for employee business expense reimbursements made under an accountable plan (that's where the employee reports his expenses to the employer and provides receipts, etc.). But reimbursements under a nonaccountable plan are wages subject to income tax withholding and social security and Medicare taxes. The same is true for auto usage. If the employee accounts for the usage, the business use is not subject to taxes. Any personal use is. If the employee doesn't account for any of the usage, it's all considered personal. If 100% of the business use is considered personal, you can't use the commuting rule or cents-per-mile rule to value the use. Only the annual lease value use is appropriate.

IRS consolidating operations and planning to increase enforcement . . . There are pluses and minuses to electronic filing. The increase in electronic filing of tax returns means cost savings and less manpower is needed to process returns. Some IRS employees will be "involuntarily separated" and the Memphis office will no longer process returns after October 2005. Starting in 2005, back-office processing for exam, collection and insolvency cases will be consolidated from 92 different locations to four. However, none of these initiatives will reduce the number of IRS employees who deal directly with taxpayers or lessen the number of office locations where taxpayers can interact directly with IRS personnel. The savings from several initiatives will allow the IRS to fill 2,200 new positions. Between 1996 and 2002, the IRS enforcement resources including criminal investigators, revenue agents and revenue officers went down by more than a quarter. Savings will allow the IRS to hire more people to pursue cheating by high-income individuals and corporations, continue our attack on abusive tax shelters, bolster our criminal investigation efforts and assist with other enforcement priorities including examination and collection activities.

Can't settle an issue with the IRS? . . . Taxpayers who have been unsuccessful in resolving issues with the IRS through normal channels have the right to contact the Taxpayer Advocate by calling, toll free, 1-877-777-4778. The Taxpayer Advocate can offer special help if an IRS action is causing the taxpayer significant hardship.

Electing out of exclusion of home sale gain . . . If you meet the requirements (generally, you must have used the property as your principal residence for 2 or more of the last 5 years and you can't use the exclusion more than once every 2 years) you can exclude $250,000 of gain ($500,000 for a married couple filing jointly) on the sale of the property. While most taxpayers should automatically use the exclusion if they qualify, some taxpayers may be better off to elect not to exclude the gain. Taxpayers who are selling more than one property that qualifies as their principal residence within a 2-year period, might want to do so. For example, during the last 5 years you used your home in Madison as a principal residence for 2 years. During the same time period you also used a home in Fitzwilliam as a principal residence. In 2003 you sold the Madison home on which you had a $150,000 gain. You expect to sell the Fitzwilliam home in 2004 for a $350,000 gain. You can exclude the entire gain on the Madison property, but then you won't be able to exclude any of the gain on the Fitzwilliam property. By reporting the Madison gain, you can exclude the $350,000 gain on the Fitzwilliam home. Check the rules carefully before making the election. You don't want to make a mistake here.

Price it right . . . We're not talking about finding the right price for your product. That's a complicated issue. But once you've selected a price or markup, make sure you follow through. We recently went into a large retailer and bought several products. One scanned at just slightly more than half the price marked on the package (it wasn't on sale). The dollar amount shown on the sticker was probably on the high side; but the scanned price was far too low. The second product scanned too high. Not only is the store losing money, the inaccurate pricing will seriously affect their forecasts and sales analysis. If you have to make quotes in your business (either for services or products), double check the numbers before sending out the quote. Making a mistake either way is not good. Too low and you'll lose your profit; too high and you'll lose the business. And, your customer may question your integrity or business acumen.

Exit strategy . . . Before signing and committing yourself to a franchise, long-term lease or supplier agreement, etc. look for a way out of the contract that won't bankrupt you. Contracts with large suppliers, landlords, franchisers, etc. will be written in their favor and it may be very costly for you to get out should the venture not develop as planned. You may not have much luck getting a franchise agreement reworded, but you may be able to have other contracts modified. Talk to your attorney before signing.

Expanding overseas? . . . Whether you're just shipping to a foreign country or setting up offices, retail stores, manufacturing, etc., be sure to investigate the market thoroughly. What may work in the U.S. could prove disastrous in a foreign county. Labor markets, consumer tastes, etc. can be very different. One way to avoid a disaster is to form a partnership with a company that knows the market. You might have to give up some profit, but that's better than failing. And, the partnership could be much more profitable than going it alone.