Small Business Taxes & Management

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

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

News On The Tax Front

Previously Reported In Daily Update

The IRS announced (IR-2004-20) a new section on its web site containing important information about abusive schemes involving employee retirement plans. The site is intended to warn promoters and plan professionals about the consequences of participating in such schemes. The new employee plans (EP) information is located in the Retirement Plans section under "EP Abusive Tax Transactions." In the new section, the IRS identifies so-called "listed transactions" involving employee retirement plans. It also provides recently issued guidance, such as Treasury regulations and IRS revenue rulings, intended to shut down transactions the IRS deems abusive. The IRS recently identified as listed transactions a scheme involving indirect contributions to Roth IRAs and one involving S corporation ESOPs. A listed transaction is one that is identical or substantially similar to one the IRS has determined to be a tax avoidance transaction by published guidance. You can find the new site at www.irs.gov/retirement/article/0,,id=118821,00.html.

In a revenue ruling some years ago (Rev. Rul. 94-38) the IRS ruled that the costs to clean up land used in the taxpayer's manufacturing process and to treat groundwater are not capital expenditures because these costs do not prolong the useful life of the land or adapt the land to a new or different use. Thus, costs incurred to clean up land and to treat groundwater that a taxpayer contaminated with hazardous waste from the taxpayer's business are deductible by the taxpayer as business expenses under Sec. 162. However, the IRS didn't rule on how environmental remediation costs were treated as inventory costs under Sec. 263A. In the current ruling (Rev. Rul. 2004-18; IRB 2004-8) the IRS held that, as with other types of deductible business costs, such as labor costs, taxes, rent, and supplies, once repair costs are determined to be deductible under Sec. 162, a taxpayer with inventories must still apply the rules of Sec. 263A to determine whether the repair costs must be included in inventory. Here, the amounts must be included in inventory costs under Sec. 263A.

In Rev. Rul. 2004-17 (IRB 2004-8) the IRS held that amounts paid or incurred in the current taxable year to remediate environmental contamination that occurred in prior taxable years does not qualify for treatment under Sec. 1341(a) (Computation of Tax Where Taxpayer Restores Substantial Amount Held Under Claim of Right) by reason of Sec. 1341(b)(2).

The IRS has announced (IR-2004-19) that it has started sharing leads on more than 20,000 taxpayers engaged in abusive tax avoidance with tax agencies in 45 states, the District of Columbia and New York City. The IRS also announced the latest results of another effort to combat abusive tax avoidance, the Offshore Voluntary Compliance Initiative (OVCI). The sharing of leads was the first large transfer of information under the terms of the new IRS-state partnership unveiled in September. More than 20,000 audit leads and other information have been shared with the states, and more information will be shared in the future. Under the terms of the partnership, IRS and the cities and states coordinate efforts to address common compliance concerns in the area of Abusive Tax Avoidance Transactions (ATAT) by working in tandem and avoid repeating each other's efforts. The initial leads transferred to states involved scams using offshore transactions, abusive trusts, employee leasing, home-based businesses, employment taxes and other tax-avoidance schemes. The IRS, states and cities will subsequently share information on any resulting tax adjustments from the audits allowing them to piggyback on the results of each other's work. The cities and states that have signed partnership agreements and that received information include: Alabama, Alaska, Arizona, Arkansas, California, Colorado, Connecticut, Delaware, District of Columbia, Florida, Georgia, Hawaii, Idaho, Illinois, Indiana, Iowa, Kansas, Kentucky, Louisiana, Maine, Maryland, Massachusetts, Minnesota, Mississippi, Missouri, Montana, New Hampshire, New Jersey, New Mexico, New York City, New York State, North Carolina, North Dakota, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, South Carolina, South Dakota, Tennessee, Utah, Vermont, Virginia, Washington, West Virginia and Wisconsin. The IRS also announced the latest results of its Offshore Voluntary Compliance Initiative (OVCI). More than 1,300 taxpayers applied to OVCI and so far the initiative has yielded more than $170 million in taxes, interest and penalties to the U.S. Treasury. In addition, the effort led to obtaining the names of 479 scheme and scam promoters. Nearly half of these promoters were previously unknown to IRS investigators. Under the terms of this 2003 initiative, taxpayers came forward, amended their returns, paid taxes, interest and penalties and furnished the IRS with information regarding the person who promoted the offshore arrangements to them.

The IRS announced (IR-2004-18) that unclaimed refunds totaling more than $2.5 billion are awaiting nearly 2 million people who failed to file a 2000 income tax return. In order to collect the money, however, a return must be filed with an IRS office no later than April 15, 2004. The IRS estimates that half of those who could claim refunds would receive more than $529. In some cases, individuals had taxes withheld from their wages, or made payments against their taxes out of self-employed earnings, but had too little income to require filing a tax return. Some taxpayers may also be eligible for the refundable Earned Income Tax Credit. In cases where a return was not filed, the law provides most taxpayers with a three-year window of opportunity for claiming a refund. If no return is filed to claim the refund within three years, the money becomes property of the U.S. Treasury. For 2000 returns, the window closes on April 15, 2004. The law requires that the return be properly addressed, postmarked and mailed by that date. There is no penalty assessed by the IRS for filing a late return qualifying for a refund. The IRS reminds taxpayers seeking a 2000 refund that their checks will be held if they have not filed tax returns for 2001 or 2002. In addition, the refund will be applied to any amounts still owed to the IRS and may be used to satisfy unpaid child support or past due federal debts such as student loans. Many low- income workers may not have claimed the Earned Income Tax Credit (EITC). Although eligible taxpayers may get a refund when their EITC is more than their tax, those who file returns more than three years late would be able only to offset their tax. They would not be able to receive refunds if the credit exceeded their tax.

There are a number of exceptions to the 10% penalty tax on early distributions from a qualified retirement plan. One of the exceptions is for medical expenses. Specifically, distributions that don't exceed your deductible medical expenses escape the tax. In Graceann Berry (T.C. Memo. 2004-11) the IRS did not questions that part of the taxpayer's early distribution was for qualified medical expenses. The taxpayer tried to avoid the penalty on the remaining part of the distribution. At the trial the taxpayer described her illness but didn't testify or provide evidence of the amount incurred for medical care during the year. Her testimony with respect to the medical care was vague. She did not provide documentary evidence and her testimony regarding the loss of the evidence was contradictory and selective. The Court denied her claim.

Be careful how you structure your transaction. Business and tax considerations could conflict. While business considerations should be uppermost, don't neglect taxes. In Robert K. and Dawn E. Lowry (T.C. Memo. 2004-10) the taxpayers filed a Motion for Reconsideration of Findings and Motion to Vacate or Revise Decision related to an earlier case (Lowry, T.C. Memo. 2003-225). In that case the taxpayers claimed that forgiveness of debt income associated with the sale of certain property was realized in 1993, not 1994. The Court noted that the taxpayers declined to address, or have misconstrued, the most salient fact; namely, that the escrow instructions , dated December 9, 1993, were issued to the Title Company on behalf of both AAL, the creditor, and the debtor partnership. The escrow instructions are worded in such a way that the title company's "acceptance" of the instructions would be completed only when various exceptions to closing title had been satisfied. These, in fact, were not completed until May 27, 1994, when title closed with the filing for recordation of the aforementioned grant deed and the issuance of an owner's title policy, the exceptions having been satisfied. It was on this date that 1994, and not 1993, was established as the year in which the forgiveness of indebtedness income was realized. The Court denied the taxpayer's motions.

A officer, shareholder or other responsible person of a business can be held personally liable for undeposited employment taxes. In Lawrence A. Mitchell (2004-1 USTC 50,113; U.S. Court of Appeals, 3rd Circuit) the Court noted that the individual was president of the corporation, served on the board of directors, and had signature authority over its various bank accounts, all of which would indicate that he was a responsible person under the law. While the individual claimed he resigned from the corporation and no longer had authority over the affairs of the corporation, his testimony was contradicted by other testimony.

One of the advantages of a partnership is that your basis is increased by the debts of the partnership for which you are liable. But there's a flip side. You may have income for the amount of the partnership debts for which you are relieved. In Life Care Communities of America, Ltd. (T.C. Memo. 2004-5) the taxpayer argued that he sold his interest in the partnership in 1989. The IRS noted that no provision in the 1989 agreement, however, precluded petitioner after January 12, 1989, from participating in the affairs of the partnership and an agreement provided a number of options for the transfer of the taxpayer's interest. Thus, the IRS claimed, the taxpayer really was divested of his position in 1990. Although the partnership did not make any actual distributions to the taxpayer, in 1989 and 1990, its income was used to make payments relating to the $20 million loan. Pursuant to Section 752(b), the partnership was deemed to have made distributions to all partners liable for such loan. Thus, in 1989 and 1990 petitioner received an economic benefit consistent with the underlying economic arrangement of the partners. The taxpayer failed to address whether or not the economic effect of the allocation was substantial. Thus, the Court sided with the IRS in finding the taxpayer had income in the amount of his share of the loan repaid.

The IRS has issued a consumer alert (IR-2004-17) advising taxpayers to beware of promoters' claims that tax debts can be settled for "pennies on the dollar" through the Offer in Compromise Program. Some promoters are inappropriately advising indebted taxpayers to file an Offer in Compromise (OIC) application with the IRS. This bad advice costs taxpayers money and time. An Offer In Compromise is an agreement between a taxpayer and the IRS that resolves the taxpayer's tax debt. The IRS has the authority to settle, or "compromise," federal tax liabilities by accepting less than full payment under certain circumstances. The OIC may be considered only after other payment options have been exhausted. If taxpayers are unable to pay their taxes in full, there are other payment options, such as monthly installment agreements, that must be explored before an OIC can be submitted. The IRS.gov web site contains complete information on the collection process and payment options. Publication 594, The IRS Collection Process, also provides helpful information on the options available to taxpayers. Taxpayers also should review Form 656, Offer In Compromise, or Form 9465, Installment Agreement Request, to determine if they qualify for either payment program. Form 656 provides detailed instructions for submitting an offer and includes all of the necessary financial forms. Some taxpayers may be exempt from the $150 OIC fee depending on income or whether the OIC is based solely on doubt as to tax liability. Taxpayers who claim the poverty guideline exception must certify their eligibility using Form 656-A, Income Certification for Offer in Compromise Application Fee.

The IRS has announced (IR-2004-16) that the Honda Insight, model years 2003 and 2004 and the Honda Civic Hybrid, model year 2004 are eligible for the clean-fuel vehicle deduction. Taxpayers who purchase any of these hybrid vehicles are entitled to a tax deduction of up to $2,000 for 2003 or up to $1,500 for 2004 for vehicles placed in service in that year. The maximum deduction was $2,000 for 2003; based on the law, it drops to $1,500 in 2004, then $1,000 in 2005 and $500 in 2006. No deduction will be allowed for vehicles placed in service after December 31, 2006. The one-time deduction must be taken in the year the vehicle was originally used. The taxpayer must be the original owner. (The Toyota Prius model years 2003 and 2004 also qualify for the deduction.) The deduction is claimed on line 33 of Form 1040 (the deduction only applies to individuals). If you purchased a vehicle in a prior year but didn't take the deduction, you may still be able to file an amended return.

In Rev. Rul. 2004-15 (IRB 2004-8) the IRS held that if a taxpayer is obligated to transfer stock to a broker as a result of a short sale and borrows stock from another broker to satisfy the obligation to the first broker by having the second broker transfer the borrowed stock to the first broker, the transfer of the borrowed stock does not close the short sale under Sec. 1.1233-1(a). The IRS also ruled on a second issue involving a taxpayer who held appreciated stock and entered into a short sale prior to June 9, 1997, of identical stock borrowed from a broker.

The IRS has issued guidance (Rev. Rul. 2004-13; IRB 2004-7) with respect to plans which meet the requirements of Sec. 416(g)(4)(H) so that they are not subject to the top-heavy rules in Sec. 416. The situations described in the ruling involve profit-sharing plans containing a cash or deferred arrangement (CODA) described in Sec. 401(k). The base situation involves a plan that provides for safe harbor matching contributions intended to satisfy the requirements of Sec. 401(k)(12)(B). The plan also permits the employer to make a nonelective contribution for any plan year at the employer's discretion. The nonelective contribution is subject to 5-year vesting described in Sec. 411(a)(2)(A) and is allocated to participants' accounts in the same ratio that each participant's compensation bears to the compensation of all participants. The plan is a calendar-year plan and covers all employees of the employer (including highly compensated employees as defined in Sec. 414(q)) who have 1 year of service and are age 21 or older. Other than elective contributions and the matching contributions, no other contributions are made to the plan for 2004 and there are no forfeitures.

President Bush wants to continue the tax cutting into 2004. Of particular interest are proposals to expand savings plans similar to Roth accounts where the funds could be used for special purposes such as the purchase of a home or college. However, significant savings may be hard to achieve in light of a growing federal deficit.

The IRS is proposing (IR-2004-14) a new schedule in an effort to increase the transparency of corporate tax return filings. The Service released a new proposed draft form, Schedule M-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More, for use by certain corporate taxpayers filing Form 1120, U.S. Corporation Income Tax Return. The new Schedule M-3 would expand the current Schedule M-1, which has not been updated in several decades. Schedule M-1 reconciles a corporation's financial accounting income or loss with the taxable income or loss reported on the Form 1120. Large and Midsize Business (LMSB) taxpayers (those with total assets of $10 million or more) will complete the new Schedule M-3 in lieu of completing Schedule M-1. Small Business and Self-Employed (SB/SE) taxpayers will not be required to complete the new Schedule M-3 and will continue to complete Schedule M-1. Other federal tax returns that also require the completion of Schedule M-1 (e.g., Form 1065, U.S. Partnership Return of Income, and Form 1120S, U.S. Income Tax Return for an S Corporation) may incorporate Schedule M-3 in the future.

In Brief:

Previously Reported In Daily Update

Educational assistance . . . You can exclude from your income up to $5,250 of qualified employer-provided education assistance. The exclusion applies to undergraduate and graduate-level courses. In order to exclude such benefits, your employer must have a formal plan that meets certain IRS requirements. The cost of courses your employer pays for that are related to your job are also excludable. For example, you work in the finance department and your employer pays for you to take an accounting or business course related to your job.

Municipal bonds not for short-term investments . . . Municipal bonds are advantageous for investors in higher tax brackets, but there's a major drawback. Since most of these bonds are not traded frequently, getting a good price on both the buy and sell side can be difficult. Brokers have been known to inflate the buying price and give you less on the sale than a mutual fund, large investor, etc. might get. And you'll probably never know you've overpaid because accurate price quotes are elusive. Getting the best price is less of a concern if you're holding for the long term. Then the tax and investment advantages are paramount. But if you're holding for the short term, you might want to work through the numbers carefully. The same advice can hold for thinly traded corporate bonds.

Word of mouth is powerful . . . Someone recently told us an old rule of thumb--a happy customer will tell four people; an dissatisfied customer will tell 14. We're not sure the numbers are on the money, but from experience we know that an unhappy customer can be costly.

Claiming the earned income tax credit? . . . There's a chance you'll get a letter from the IRS if you claim the credit on this year's return. The IRS will examine approximately 429,000 EITC claims this year through the traditional audit process and also by testing new, less burdensome ways to reduce erroneous claims in three high-risk areas of qualifying child residency, filing status, and unreported income. These initiatives affect a very limited number of the 20 million EITC claimants, but the results will help fine-tune more effective and less intrusive ways to curb the high rate of erroneous claims, estimated at nearly one-third of the 1999 claims.

Partial first year requires adjustment . . . If your first year of business isn't a full year (e.g., you start the business April 1 and end the tax year December 31), you cannot use the MACRS percentage tables to determine depreciation for the short tax year. The rules here can get very complicated. While you certainly can do the calculations by hand, this is certainly one time when using tax software will pay off.

Expense option on trade-ins . . . For 2003 you can expense up to $100,000 in equipment purchases. While the equipment can be new or used, if you purchase the asset using a trade-in as part of the price, you can only use the expense allowance on the excess of the cost of the property over the undepreciated cost of the property traded in. For example, you purchase a new truck with a price of $25,000 by paying $10,000 cash and trading in your old truck. You can only take the Section 179 expense election on $10,000.

Used equipment . . . You can take the full Section 179 expense election ($100,000 for 2003) on new or used tangible personal property. And most of the depreciation rules apply equally to new or used equipment. But the 30% and 50% bonus depreciation can only be used on new equipment (technically, property where the first use begins with the taxpayer). Keep that in mind when analyzing purchases and preparing your return.

EFTPS online--If you are going to owe taxes when you file your federal tax return, consider paying over the Internet through the Electronic Federal Tax Payment System (EFTPS). The service is free. You can enroll in EFTPS-OnLine via an official government site, www.eftps.gov. After enrollment, you will receive a confirmation package by mail with instructions for obtaining an Internet password by phone. For added security, a unique Personal Identification Number (PIN) will be separately mailed. Businesses obtaining an Employment Identification Number (EIN) will automatically be pre-enrolled in EFTPS to make all their federal tax payments. Businesses will receive a mailing that contains their PIN and instructions for activating their enrollment. With EFTPS-OnLine, you can pay all federal tax payments including corporate, excise and employment taxes as well as your quarterly estimated tax payments. EFTPS allows individual taxpayers to schedule payments up to 365 days in advance, and businesses can schedule payments up to 120 days in advance of the tax due date. Other features include an instant, printable EFT Acknowledgement Number as documentation of every transaction and access to 16 months of tax payment history. For more information on electronic payment of taxes, visit the EFTPS Web site at www.eftps.gov or call toll free 1-800-555-4477 or 1-800-945-8400.

File a police report . . . Your loss (break-in, employee embezzlement, credit card fraud, etc.) may be fully covered by insurance, but you should always file a police report. There may be little or nothing the police may be able to do, but filing the report can be crucial to getting reimbursed by your insurance company, credit card issuer, etc. It can also be vital in support for a tax deduction if you have a net loss after any recovery.