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
Employee Discounts--Part I--The best fringe benefits you can provide an employee are those that are deductible by the business but not taxable to the employee. Employee discounts are prefect, but you've got to obey some simple rules.
Salaries Associated With Merger Must be Capitalized --The IRS has won another case, forcing taxpayers to capitalize even more expenses.
Alternative Minimum Tax --It's no longer for the rich. The number of taxpayers subject to the tax is increasing rapidly each year. Here are the reasons and the items that can trigger the tax.
Before You Destroy Those Records--Thinking of destroying some records before they're subpoenaed? Read this before doing so.
In Brief:--Tax, business, and personal finance tips.
Previously Reported In Daily Update
Senate Finance Committee Chair William V. Roth Jr. is scheduled to introduce a bill entitled The Retirement Savings Opportunity Act of 1999. the first week of March. The bill would increase the maximum contribution limits for Roth IRAs, 401(k) plans, 403(b) annuities, 457(b) plans, and SIMPLE plans. The bill would also eliminate income restrictions on both traditional and Roth IRAs as well as increase the income cap for conversions from traditional to Roth IRAs. While there's plenty of other legislation in the hopper, this one stands a good chance of passage.
If social security reform must come before tax cuts, we could be in for a long wait. In a recent meeting of the House Ways and Means Committee, tempers flared over an assumed noncontroversial joint resolution.
IRS Announcement 99-18 corrects several errors to the instructions for Form 8606 and the instructions for certain line items on the form. Taxpayers who may be affected include those making nondeductible contributions, those making conversions of traditional IRAs to Roths and back, and how to compute the 10% additional tax for early distributions. The announcement also provides a comprehensive example.
The IRS has announced that it has released the following Publications:
In Rev. Rul. 99-16 the IRS announced that the interest rates on under- and overpayments for the calendar quarter beginning April 1, 1999 will increase. The rate will be 8% on under- and overpayments (8% and 7% for corporations). Our IRS Interest Rates have been updated to reflect the new rates.
The IRS has re-released Publications 17, 563, 508, 516, and 529 to correct errors. It has also issed Publication 3114 on Examinations and Compliance Reviews.
In Publication 3125, An Important Message for Taxpayers with IRAs, the Service is cautioning taxpayers with IRAs should be alert to questionable advertisements and solicitations for 'IRS Approved' or 'IRA-Approved' investments. These advertisements or solicitations, often for highly speculative types of investments, mislead by falsely claiming the IRS has approved a particular investment. The IRS never approves any forms of IRA investments.
In an IRS news release (IR-1999-22) the Service announced that many taxpayers are not properly claiming the child credit. While they have checked the box on the front of the return indicating one or more children qualify, they haven't actually taken the credit on the second page. The IRS has estimated more than 30,000 taxpayers may have done this. The Service has corrected a number of these returns, but some may have slipped through. Check your return carefully before sending it in. And don't forget there is an additional child tax credit for certain people with more than two children. However, you've got to use Form 8812 to claim the credit.
The IRS has announced that the following publications are now available:
In addition, Publication 970, Tax Benefits for Higher Education, has been revised.
You've got to be in a trade or business in order to deduct business expenses. In John Paul Massa (T.C. Memo. 1999-63) the taxpayer, a CPA, traveled to Russia to investigate a business venture. He incurred $21,000 of expenses. He also acquired office and warehouse space in Colorado. The Court held the taxpayer was not in a trade or business. While discussions were held concerning potential business, there were no completed transactions. Thus, the outlays were 'start-up expenditures.' The deductions were disallowed.
It's great to win the lottery, but how will you value a 20-year payout of the lottery winnings in your estate if you die? The IRS addressed the question in a recent Technical Advice Memorandum (TAM 199909001). The lottery winners transferred their interest to a family limited partnerships. One woman's partnership interest was transferred to a revocable living trust. The estate valued the remaining 19 years of a 20-year payout by first discounting the payout to a present value using the interest rate based on a AAA rated general obligation bond. The estate then discounted the payment by the federal income taxes payable (at 39.6%) and a 25% discount for lack of marketability. Additional discounts were taken for a lack of control of the partnership (20% discount) and lack of marketability of the partnership (25%). The IRS said that the section 7520 standard annuity factor must be used for present valuing the payment stream. The IRS also held that, when valuing the winnings payable to the partnership no discount could be taken for marketability or income taxes payable. The Service didn't comment on the other marketability discount or the the discount for lack of control.
We've mentioned in previous issues that cashing in a life insurance policy can be costly from a tax standpoint. Your basis is equal to the total premiums you paid. Any amount you receive over that is fully taxable at ordinary income rates. In a recent Tax Court case (Stephen L. Atwood, et ux.; T.C. Memo. 1999-61) the taxpayers each purchased single premium life insurance policies ($25,000 for the husband; $50,000 for the wife). The taxpayers borrowed the maximum, an amount equal to the cash surrender value of the policies. Interest was payable on the amounts borrowed and any unpaid interest was added to the loan. The taxpayers made no payments on the loans. Their outstanding loan balances grew to $39,400 and $73,300, respectively. The insurance companies terminated the policies reporting income of $14,800 to the husband and $23,300 to the wife. While they received 1099-Rs, the taxpayers did not report did not report the income. The Tax Court sided with the IRS, saying the cancellation of the loans constituted a payment of the policy proceeds to the taxpayers and was income. The taxpayers argued that they should get a deduction for the interest paid. The Court held the amount was a nondeductible personal expense. The Court also allowed the imposition of the accuracy- related penalty for a substantial understatement of tax.
Senator Byron L. Dorgan has introduced legislation that would allow small business owners and farmers to deduct 100% of their health insurance costs as a business expense. Under current law that will automatically happen in 2003. Senator Dorgan's bill would make that happen in 1999.
More pension simplification proposals are being talked about in Congress. Senate Finance Committee member Charles E. Grassley has indicated that additional pension reform looks promising this year. He, along with Senate Finance Committee member Bob Graham and other Senate taxwriters have introduced a bill that would, among other things, allow increase the contribution limits, ease the rules governing top-heavy plans and create a nondiscrimination safe harbor for employers offering a 401(k) plan.
You just sold all the interest in your sole proprietorship. You're collecting the payments on the installment basis and are getting interest as well as principal payments. Where do you report the interest income? In George R. and Donelle C. Hawthorne (T.C. Memo. 1999-31) the taxpayers reported the inocme on Schedule C. The Tax Court held it must be reported on Schedule B (interest and dividend income) since the interest was not related to carrying on a trade or business. In fact, about the only interest income that should be reported on Schedule C is that from overdue accounts receiveables.
If you hold real estate for the purpose of renting it or even speculating on scoring a capital gain on the sale, you can deduct associated expenses related to the production of income. However, that wasn't the case in George R. and Donelle C. Hawthorne (T.C. Memo. 1999-31). The taxpayers could not show they held the properties for the production of income. Evidence showed they had not made a decision on what to do with the properties. If anything, they were inclined to give the properties to family members.
The IRS is often quick to challenge an advance to an employee an employer considers a nontaxable loan rather than salary. In this case (James J. and Sandra A. Gales; T.C. Memo. 1999-27) the taxpayer was able to show that advance commissions he received as an insurance salesman were loans. The advances were against future commissions computed on policies sold. They were payable on demand and, any loan amount that exceeded the actual commissions bore interest. Moreover, the insurance agent was personally responsible for any amount that exceeded the commission offset.
Distributions from a regular (C) corporation could be dividends (taxable at ordinary income rates), a nontaxable return of capital, or capital gains from the sale or exchange of property (taxed at no more than 20%). It depends on the facts. In George R. and Donelle C. Hawthorne (T.C. Memo. 1999-31) the Tax Court found that the taxpayer received distributions from various companies, some of which were taxed as capital gains, some as ordinary income. Some distributions were clearly dividends, but others were deemed capital gains since the stockholders could not show any basis in the stock.
President Clinton has indicated that he is willing to deal on tax cuts. That would improve the chances of a tax bill passing this year. Indeed, the administration's 2000 budget proposal provides a number of tax cuts, many for small businesses. However, there are also a number of provisions for closing tax loopholes.
Providing a discount to employees or allowing them to use services for free ranks high on the list of desired perks. Unfortunately, the IRS has rules as to what's allowed and what's not. And if the service, benefit, discount, etc. doesn't meet the IRS rules, the unallowed value must be included in the employee's income. If you fail to do so the company can be liable for additional FICA, FUTA, and SUTA taxes. There can also be penalties.
Employee discounts can be broken down into two categories-- no-additional-cost services and employee discounts. While many of the rules are similar, there are some important differences. In this article we'll deal with the no-additional- cost service.
A no-additional-cost service is a service provided to employees at no or a reduced cost. Generally, there is no tax effect to the employee or the employer. The best example is free flights provided to airline employees. In order to qualify as a no-additional-cost service, two criteria must be met:
Substantial additional cost. The first requirement that must be met is that there is no substantial additional cost in providing the service. When determining cost, any revenue that may be lost from serving the employee rather than a paying customer must also be taken into account. Whether an employee incurs substantial additional cost must be determined without regard to any amount paid by the employee for the service.
When considering whether substantial additional services have been provided, the employer must take into account the amount of time spent by other employees in the process of providing the service. That's true even if the time spent by the other employees would be idle or if the services are provided outside normal business hours. On the other hand, an employer generally incurs no substantial additional cost if the services provided to the employee are merely incidental to the primary service provided by the employer. A couple of examples may help.
Example 1--Madison operates a large auto repair shop During slow times Madison lets employees use the lifts, electronic equipment, etc. to work on their own autos. Madison does not let other employees assist nor does it allow the use of consumables (e.g., welding gas) or parts. This should qualify as a no-additional-cost service.
Example 2--The facts are the same as in example 1, but any employee who is not working at the time can assist the employee working on his car. This would not qualify.
Example 3--Island Airlines provides free flights to employees when there's excess capacity. Island's flight attendants serve food on the flight. The flight and services qualify as a no-additional-cost service despite the free meal because the providing of a meal is incidental to the primary service of air transportation. (The same would hold true for maid service in a hotel.)
Thus, in order to qualify as a no-additional-cost service, four conditions must be met:
Some services will never be eligible because they are not excess capacity services. For example, lawn mowing provided free to an employee of a landscaping contractor. There is no excess capacity since someone must be put on the job that wouldn't have been there. Similarly, the purchase of stock for employees by a brokerage firm, or the providing of insurance by an insurance company, can never qualify under these rules. However, they may fall under a special rule which allows for a discount of up to 20% for services.
An exclusion is available to an employee of one employer for a no-additional-cost service provided by an unrelated employer if:
A written agreement is not required if the businesses are commonly controlled.
Example--SkiTel runs a chain of motels in areas with ski resorts. Tropical Resorts, an unrelated company, operates motels in Florida, the Bahamas, etc. Both companies agree to let employees of the other company use their facilities for 50% off.
Line of business requirement. A no-additional-cost service or a qualified employee discount is only available with respect to property or services that are offered for sale to customers in the ordinary course of the same line of business in which the employee receiving the property or service performs substantial services. Thus, an employee who works in the retail store of a large corporation can't receive a discount on cable TV services provided by the same company. An employer is considered to have more than one line of business if it offers services (or goods) for sale to customers in more than one two-digit code classification of the Enterprise Standard Industrial Classification Manual (ESIC Manual).
There are some exceptions to this rule. First, even if an employer has several lines of businesses, they may be considered as one if it is uncommon in the industry for any of the separate lines of businesses to be operated without the others. Second, retail operations located on the same premises that are in separate lines of businesses may be considered as one if the merchandise were offered for sale at a department store. Third, employees who work for more than one line of business are treated as working on all the lines in which they are associated. For example, clerical staff that perform functions for one or more lines of businesses can get discounts on all the lines for which they perform functions. The same would be true for management.
The line-of-business requirement can be waived under a special rule. The rules get complicated. You'll need professional help here.
Definition of employee. In order for the no- additional-cost service to be tax-free, the recipient of the service must be an employee. An employee includes a current employee, the spouse or dependent children of an employee, former employees who have left due to retirement or disability, and widows and widowers of deceased former employees.
Other considerations. No-additional-cost services are only tax free to highly compensated employees if there is no discrimination in favor of those employees. We'll cover this in some depth in our next issue.
No-additional-cost services don't include flights on the company airplane or on charter flights. Special rules apply.
Generally, if a discount qualifies as a no-additional-cost service, the value of that service is not included in the income of the employee. If, for some reason one of the requirements is not met, the value of the service must be included in the employee's income and is subject to FICA and FUTA taxes.
We'll discuss discounts on merchandise and services in the next issue.
Salaries Associated With Merger Must be Capitalized
Expenses associated with the acquisition of a business must generally be capitalized. Expenses such as consultants' fees to evaluate a potential acquisition. But not only outside consultants' fees must be capitalized. The salaries and related expenses of employees must also be capitalized. For example, the chief financial officer spends 2 months full-time evaluating and analyzing a potential acquisition candidate. The portion of his salary and related expenses (travel, entertainment, etc.) must also be capitalized. Fortunately, these expenses can be written off over a 60-month period.
But what about the acquired company? That party is going to incur legal, accounting, consulting, etc. fees. In an earlier case (INDOPCO) the Supreme Court held that such costs incurred by the acquired party had to be capitalized. (Check with your adviser in the case of an unfriendly takeover.) In a recent case (Norwest Corp., et al.; 112 TC--, No. 9) Norwest Corp., through another entity, acquired all the stock of Davenport Bank and Trust Co. by means of a tax-free transaction. This was a friendly, not a hostile takeover.
Davenport incurred investigatory expenses in connection with the merger. Davenport wanted to make sure that the community would be served and that the merger was in the best interests of the stockholders. In addition to outside legal, accounting and financial assistance, certain officers of Davenport worked on various aspects of the transaction. None of the officers were hired specifically to render services on the transaction; all were hired to conduct Davenport's day-to-day banking business. The company's participation in the transaction had no effect on the salaries paid to its officers. Of the salaries paid to the officers during the year at issue, $150,000 was attributable to services performed in the transaction. The company deducted these salaries on the its income tax return for the year.
The taxpayer realized that the cost of the outside consultants hired by Davenport had to be capitalized, but argued that the officers' salaries should be currently deductible because the annual salaries were paid to conduct Davenport's everyday banking business, and, although they worked on the transaction, this work was tangential to the specific duties they were hired to perform.
In INDOPCO the Court held that investment banking fees and expenses, legal fees and expenses related to advice given to the taxpayer and its board on their legal rights and obligations with respect to the transaction, the participation in negotiations, the preparation of documents, and the preparation of a request for a ruling from the IRS on the tax-free acquisition plan had to be capitalized. The rationale was that it was in the taxpayer's long-term interest to shift ownership of its stock to the acquirer. In this case only direct costs were at issue.
In this case, the IRS argued that not only the direct costs had to be capitalized (which the taxpayer conceded to), but also the indirect costs. That is, the portion of the salaries of officers who worked on the transaction.
The Court cited another case (Lincoln Savings & Loan Association) that concluded that professional fees directly incurred in reorganizing or restructuring a corporate entity for the benefit of future operations were not deductible.
The Court noted that even though the disputed expenses in this case were mostly preparatory in nature, they enabled Davenport to achieve the long-term benefit that it desired from the transaction, and the fact that the costs were incurred before Davenport's management formally decided to enter into the transaction, did not change the fact they were sufficiently related to the transaction.
Solutions here are on a case-by-case basis. There's probably not much you can do to salvage the deductions, but talk to your tax adviser while still in the early stages of negotiation.
Think you don't have to worry about the alternative minimum tax (AMT)? Think again. Think you're not in a high enough bracket? Think again. A married couple with $100,000 in salary could be hit. You don't have any tax shelter type income? You don't need it. All you need is certain itemized deductions. In fact, it's possible to get hit with the tax if you take the standard deduction. While the threshold depends on a number of factors, even income as low as $50,000 doesn't guarantee you'll escape.
Unfortunately, more and more individuals are finding themselves subject to the tax. There are a number of reasons. One is that the exemption amount ($45,000 for a married couple filing jointly, $33,750 for a single individual or head of household) isn't indexed for inflation. Thus, as incomes rise, the exemption is worth less. Second, certain items that trigger the tax are becoming more commonplace. For example, the deduction for taxes, the effect of incentive stock options, and long-term capital gains. (Note, there's a separate alternative minimum tax for regular corporations. We won't deal with that here.) However, if you are a shareholder in an S corporation, partner in a partnership (or member of an LLC), or do business as a sole proprietorship, certain preference items are passed through and affect your personal alternative minimum tax.
What is the alternative minimum tax? Technically, it's really a parallel tax system. From a practical standpoint, you compute your tax both the regular way and using the alternative minimum tax computation. The if your tentative minimum tax is more than your regular tax, the difference is added to your regular tax.
How do you compute the tax? While the computation is involved (unless you like punishment, it's best done by computer), the approach can be simplified for illustrative purposes:
Start with your taxable income before exemptions
Add adjustments and preferences
Less minimum tax exemption amount
Equals Alternative minimum taxable income (AMTI)
To compute the tax, multiply your alternative minimum
taxable income by 26%, or 28% if the AMTI is more than $175,000
($87,500 if married filing separately).
You'll compute the difference between the alternative minimum tax and your regular tax. This amount is added to your regular tax.
While the tax rate is lower (26% or 28%) than the regular tax rate, the rate is applied to a higher income base. For example, you don't get to deduct your dependency exemptions, taxes, some of your medical expenses, certain home mortgage interest, some accelerated depreciation, etc.
What factors affect your alternative minimum tax liability? First, there are adjustments and preferences. We'll discuss these in some detail below. Second, your alternative minimum taxable income. Since that depends on your regular income plus adjustments, the higher your income the higher the alternative minimum tax rate and the lower your alternative minimum exemption. Third, your regular tax. If you're deep in the 39.6% bracket and you have few preferences, you're unlikely to get hit with the minimum tax. However, if you have significant capital gains that are taxed at 20%, your overall tax will be lower and there's a greater chance the alternative minimum tax will be higher.
Adjustments and Preferences
The law makes a distinction between these two, but we won't get technical here. The bottom line effect of each is the same. Remember, the starting point is your taxable income before personal and dependent exemptions.
Standard deduction. If you took the standard deduction for regular tax purposes, add that amount back.
Medical and dental. For minimum tax purposes, only the amount of your medical expenses that exceed 10% (not the 7.5% used for regular tax purposes) of your AGI is deductible for the AMT.
Taxes. Taxes are not deductible for alternative minimum tax purposes. Add all of them back.
Refund of taxes. If you can't deduct taxes, you shouldn't have to report a refund of taxes as income for minimum tax purposes. And that's what happens in practice. This is a negative adjustment.
Certain interest on a home mortgage. For regular tax purposes you can deduct the interest on a principal residence and one second home. You can also deduct qualifying interest on a home equity loan. For minimum tax purposes, generally, any interest on a home mortgage other than that used to buy, build, or substantially improve your principal residence or a second home is not deductible. For example, interest on a home equity loan or a refinancing where the amount financed is more than the original loan.
Investment interest expense. Investment interest (interest paid to buy or carry investments such as stocks, bonds, etc.) is deductible for regular tax purposes, but only to the extent of investment income. For example, if you have $1,000 of investment interest and only $800 of interest, dividends, short- term gains, etc., you can only deduct $800 of investment interest. The same rule applies for minimum tax purposes, but you must refigure your investment interest using investment income for minimum tax purposes.
Miscellaneous itemized deductions. Tax preparation fees, investment advisory fees, uniforms, etc. that you were able to deduct (the amount that exceeded 2% of your AGI) must all be added back for minimum tax purposes.
Note that charitable contributions, casualty and theft losses, the deduction for impairment-related work expenses, the deduction for a share of estate tax for income in respect of a decedent, the deduction for amortizable bond premium, and certain other deductions aren't miscellaneous itemized deductions. Thus, these deductions require no adjustment because they are deductible for minimum tax purposes.
Unfortunately, one of the biggest deductions, that for unreimbursed business expenses, does fall under the general rule. These expenses are not deductible for minimum tax purposes. If you're an employee, try to get reimbursed by your company. If you own your own business, do an expense report and have the business reimburse you.
Post-1986 depreciation. This applies to S corporation shareholders, partners, sole proprietors and owners of rental property. You've got to recompute your depreciation deduction on property placed in service after 1986. Different, longer lives, apply and you must compute depreciation using a 150% declining balance method instead of the 200% method used for regular tax purposes. The difference is an add-back for minimum tax purposes. If you're a partner, etc., your K-1 will give you the amount to be added back.
How much of an effect this will have depends on the amount of property you have in the business. In the case of a service business, the effect may be minimal. For manufacturers, the adjustment could be substantial.
There are some bright sides. First, if you lease property (assuming it's a true lease, not a financing lease), there's no adjustment since there's no depreciation. Second, if you use the Sec. 179 expense option, there's no adjustment. Third, as equipment gets older, the depreciation for minimum tax purposes will exceed that for regular tax purposes. Since you net the positive and negative adjustments, you may actually have a net negative adjustment. That is, your depreciation adjustment may actually reduce your minimum tax liability.
The rules here are complicated. You'll almost assuredly need professional help. The rules change slightly for property placed in service after 1998.
Tax Tip--If you're starting a new business and you're using a lot of equipment, you might want to elect to depreciate the property using the alternative depreciation system, the same as used for minimum tax purposes. Losses generated by big depreciation deductions may be unused while leading to a minimum tax problem. You've got to work through the numbers.
Adjusted gain or loss. Most gains or losses you report on the sale of a business (or investment) property is dependent on the amount of depreciation taken. Since the depreciation taken for minimum tax purposes may be different from that for regular tax purposes, your gain or loss will be different.
Example--Your business purchases a truck for $20,000. At the end of 2 years you sell it for $15,000. For regular tax purposes you took $10,400 of depreciation. You'd have a gain on the sale of $5,400. For minimum tax purposes the gain would be only $3,100. The difference ($2,300) would be a negative adjustment.
Incentive stock options. This can be the big one. The exercise of an incentive stock option doesn't generate any income for regular tax purposes. If the stock is held for at least a year from the date received and for at least two years from the date the option is granted, the difference between the selling price and the option price is a long-term capital gain.
However, for minimum tax purposes, the difference between the fair market value of the option and the option price is an adjustment for minimum tax purposes.
You can avoid minimum tax treatment by disposing of the stock before the end of the year in which the option is exercised. In the past, tax planners often suggested selling the stock before the end of the year to avoid the minimum tax effect. However, with the tax rate on long-term capital gains down to 20%, this advice may not make sense. Work through the numbers with your tax adviser. It may make more sense paying the minimum tax and holding out for long-term gain treatment.
Tax-exempt interest on private activity bonds. Municipalities sometimes issue tax-exempt instruments called private activity bonds. These bonds are tax-free for regular tax purposes, but not for the minimum tax. The income must be added back. Many tax-exempt mutual funds invest a portion of their assets in these bonds. Fortunately, the percentage is usually low (often less than 10%).
Passive activities. There can be a difference between your income or loss from passive activities computed using the regular tax system and the minimum tax system. This difference is an adjustment.
Beneficiaries of estates and trusts. A trust or estate can also generate adjustments and preferences for minimum tax purposes.
Research and experimentation costs. If you're an owner in an S corporation, partnership, etc., don't materially participate in the business and the business deducted these costs, you must recompute your deductions by capitalizing them and amortizing them over 10 years.
Circulation expenditures. If your sole proprietorship, S corporation, etc. deducts the expenses of establishing, maintaining, or increasing the circulation of a periodical, you must recompute the deduction for minimum tax purposes by capitalizing the expenses and amortizing them over 3 years.
Long-term contracts. When computing the alternative minimum taxable income, you must use the percentage-of-completion method for long-term contracts. You must use the cost-to-cost method to determine the degree of contract completion. No AMT adjustment is required for any home construction contracts. This is a technical area. Check with your accountant.
Depletion. If your depletion deduction for the year exceeds your adjusted basis in the property at the end of the tax year, the difference is a preference item. The preference must be determined separately for each property. For tax years after 1992, the preference doesn't apply to independent oil and gas producers or royalty owners under IRC Sec. 613A(c).
Gain on sale of small business stock. Certain stock of a small business issued after August 10, 1993 qualifies for special capital gain treatment. Generally, half of the gain is excludable, but the tax on the gain for regular tax purposes can't be less than 14%. For tax years ending after May 6, 1997 42% of the amount excluded from gross income is a tax preference.
Tax Tip--If you're selling your business this could be the big one. The special benefit only applies to C corporations, but the adjustment could be significant.
Net operating loss. Individual taxpayers are allowed a net operating loss. If you have one, you've got to recompute the NOL using the rules under the alternative minimum tax. This could be a positive or negative adjustment.
Phaseout of itemized deductions. If your AGI is above $124,500 ($62,250 if married, filing separate) your itemized deductions are phased out. You're allowed an adjustment for this phaseout. The effect is to reduce your minimum tax liability.
Related adjustments. If you have investment interest, post-1986 depreciation adjustment, a different gain or loss on a sale for AMT purposes, incentive stock options, an adjustment for passive activities, circulation expenditures, pre-1987 depreciation, or adjustments for depletion, long-term contracts, research and experimentation, the capital gain exclusion, or any of the adjustments described immediately below, you may have to refigure any income or deduction item based on an income limit other than your regular AGI. The affected items include:
Other adjustments and preferences. There are several other adjustments and preferences. We'll only mention them here since they apply to a very limited number of taxpayers. They include installment sales, intangible drilling costs, large partnerships, mining costs, patron's adjustment, and tax shelter farm activities.
Exemptions, Tax Rate, and Credit
Exemptions. After adjusting your regular taxable income for adjustments and preferences, you arrive at alternative minimum taxable income. You're allowed an exemption that will reduce that amount before applying the tax rate. The exemption is $45,000 for a married couple filing jointly, $33,750 for a single individual or head of household, and $22,500 if you're married filing separately. As mentioned earlier, the exemption is phased out if your AGI exceeds certain levels. For a married couple filing jointly the phaseout starts at $150,000 and is complete at $330,000; for a single individual or head of household, the phaseout starts at $112,000 and is complete at $247,500; for married, filing separately, special rules apply.
A child under age 14 is also subject to the minimum tax. In fact, the minimum tax can apply at a much lower level. The rules are similar, but a child is only entitled to a $5,000 exemption. This exemption is indexed for inflation.
Tax rate. The tax rate is 26% on the first $175,000 ($87,500 if married filing separately) of alternative minimum taxable income and 28% on amounts over $175,000.
Credit. You may be entitled to a credit for a portion of the alternative minimum tax paid. The credit is based on items that produce a timing difference and can be used to offset taxes in a future year. Amounts considered permanent exclusions (e.g., deduction for taxes) can't generate any credit.
Predicting your Exposure
Here are some guidelines for when the alternative minimum tax will begin to affect you. If your AGI is $50,000, you've got to start worrying about the tax if your adjustments and preferences exceed about $22,000 for a single individual or $25,000 for a married couple filing jointly. If your AGI is $150,000, the cut-in points are about $29,000 and $31,000. If your AGI is $200,000, the thresholds are $31,000 and $33,000.
While these amounts can be used as a guide, the actual cut- in point will also depend on the number of personal and dependent exemptions you take, and the amount of any long-term capital gains.
Before You Destroy Those Records
You've received a letter from the IRS notifying you of an audit. Or you're being sued by a former employee. Or by a customer. You've got some incriminating documents so the best idea is to shred them before the IRS or the other party's attorney can get their hands on them? Wrong. You could be asking for much more trouble.
There have been a number of court cases on the issue. While specific sanctions for destroying documents can vary widely depending on the circumstances and the court, there can be some disastrous consequences.
IRS. In one tax case (Spies, 43-1 USTC 9243) the Supreme Court found that the taxpayer's destruction of records was a willful attempt to defeat and evade tax. An affirmative willful intent may be inferred from conduct such as the destruction of books and records. The Supreme Court likened the destruction of the records to keeping a double set of books, making false entries or alterations, or false invoice or documents and concealing assets or covering up sources of income. That could easily be construed as one of the 'badges of fraud.' You might be better off giving the IRS moderately incriminating evidence than giving them the opportunity to assert fraud.
In another case (Stringer, 84 T.C. No. 46) the taxpayer received a subpoena requiring her to produce a diary. The taxpayer's attorney first allowed, then withdrew the diary from the record. The taxpayer provided the Court with copies of some pages. The Court cited the 'spoilation presumption.' The theory here is that if the taxpayer destroyed or refused to present the documents, they would be unfavorable to the taxpayer's case. That is, a presumption is created against the person destroying the records. In this case the Court found the unavailability of the diary particularly incriminating since she generally kept meticulous records.
Nontax cases. In some cases where records have been destroyed, the courts have ruled in favor of the other party, granting a default judgment. Some courts have not been so brutal. In some cases they require the other party to show that the destruction of documents was done in bad faith before ruling in that party's favor. The court may be more lenient if the same information can be gathered from other sources. For example, you destroy purchase orders and invoices. The other party could obtain the same information from your vendors.
Avoiding the problem. This doesn't mean you must hold on to documents forever. You can't be held liable if you destroy the documents in the ordinary course of business. For example, you have a policy of destroying all invoices after 5 years. You do so only to get sued later and subpoenaed to produce the documents. You should be off the hook.
But that means the business must have a policy of when records are destroyed. Few small businesses do. And your policy can't require the destruction of the documents before the end of a normal retention period. For example, your state requires you to maintain payroll records for 6 years. If your policy is to destroy all records after 5 years, you may still be in trouble. Talk to your accountant and attorney. They should be able to help in setting up a formal record retention policy.
You may still be able to escape the wrath of the court if you destroyed the records before you were aware of any pending litigation. This one can be trickier. Clearly, if you've been formally apprised of a lawsuit or an audit, destroying records after that time could put you in hot water. But what if there's just a hint of a problem? For example, a vendor just threatens to sue you. Some courts have held that that's enough notice.
If you have any doubts at all, talk to your attorney before destroying any documentation.
Previously Reported In Daily Update
What are your chances of an audit? . . . The most recent statistics are for the fiscal year October 1, 1996 through September 30, 1997, and total audits dropped by somewhat over 15%. But audits were up in a number of areas. For example, if your total positive income on a Schedule C is less than $100,000, your audit chances went down from the prior year. If your C income was over $100,00, your chances increased. And audits of corporations are up in almost every category. The larger your corporation is (in total assets) the greater your chances of an audit. For example, if your assets are under $250,000, your chances of an audit in 1997 were about 1.19%. If your assets were between $250,000 and $1,000,000, your chances increased to 3.52%. Break the $1 million mark and they jump again to almost 8%. That's another reason for not putting real estate into the same entity as your operating business. By keeping them separate you lower your total assets, and maybe your audit chances.
Can your employees bind you? . . . If an employee routinely signs purchase orders, checks, accepts orders, etc. suppliers, customers, etc. will assume that he or she can bind the company. It's called implied authority and it can resulting in just as binding a contract as if the employee had actual authority. That could prove disastrous, particularly if the employee wants to harm the business. Set a company policy on the dollar limits that employees are allowed to sign for on their own. For example, you might want to set a dollar limit on purchase orders, sales contracts, etc. The limit could be such that a supervisor, vice president or even the president has to sign for larger amounts. Alternatively, you can require that amounts above a certain dollar level require two signatures.
Mutual funds on steroids . . . What are they? They're funds that leverage their performance by buying and selling index options and futures in addition to stocks. If they make the right moves your return can be outstanding. One fund returned over 180% last year; another just over 100%. But if the manager makes the wrong pick, the downside can be scary. One fund was down over 50%; another down over 60%. That means you could have lost over half your money. Read your prospectus carefully. If you're investing in a fund like this, don't do it with your child's college money.
Corporate bylaws . . . In a closely held corporation your bylaws can be very important. Properly worded they can stop a minority shareholder from asserting control in your business. But be careful. If you require too high a majority, or even a unanimous vote, you could find yourself in trouble. A minority shareholder could veto the acquisition of real estate, the sale of a major piece of equipment, etc. Talk to your attorney.
Cellular phones . . . They're considered 'listed property' by the IRS. That means rules similar to those that apply to cars apply to cell phones. You should maintain a log for all calls, and only business calls are deductible. Fortunately, most providers will give you a detailed list of incoming and outgoing calls. Be sure you can identify the party called as business or nonbusiness and allocate the bill accordingly. Keep in mind that the IRS can easily secure these records.
I.P.O.'s a no brainer? . . . Maybe not. Most investors consider getting in on the opening on an I.P.O. (initial public offering) is a guarantee for a killing. That may not be true. You hear about an I.P.O. that's skyrocketed at the opening. No one likes to talk about one that's fizzled. You won't hear about it from your broker and your buddy who bought in won't be bragging either. The bottom line? Don't buy in just because it's an I.P.O. Do your homework on the company. And, if the company is a small one, you might just want to consider bailing out early rather than holding for the long term. Some studies have shown that I.P.O.s of small companies don't do nearly as well long term as those that are well established before going public.
Basis in mutual funds . . . One of the most annoying parts of preparing your tax return is coming up with your cost basis in stocks, bonds, or mutual fund shares sold. The problem is especially acute with mutual funds since you may have received dividends that were reinvested, that is, used to purchase additional shares. That will increase your basis and result in a lower profit or greater loss on a sale. But doing the computations can be more than tedious. Many mutual fund companies now provide you with your basis when you sell. However, be careful. The IRS allows you to compute your basis in any of several different ways. The mutual fund company will pick just one. And some mutual funds don't add reinvested dividends to your basis . That could prove costly. Best advice? Check the fine print on the mutual fund statement that provides your cost basis, and keep your own records if you want to play it safe.
Selling your business? . . . If someone makes an offer for your business, consider what the business is worth to the buyer. While a competent appraiser may value your business at a certain price, there may be one or more buyers who would be willing to pay much more. Your business may be a particularly good fit with his, or the buyer may need your expertise, patents, name, etc. Or perhaps he can market your product at little additional cost. Try to figure out what your business would add to his bottom line. For example, if he can just add your products to his salesmen's regular offerings, adjust your income statement by reducing your selling expenses accordingly. That will increase your profits and give you a truer picture of your profitability and value.
Investment advisory fees . . . You should be able to get a tax benefit for them, unless the services relate to tax-exempt investing. But are the fees deductible or must they be capitalized? If the services are general in nature, such as planning your portfolio, should be deductible as a miscellaneous itemized expenses, subject to the 2% floor. If the fee relates to a specific investment, it could be a considered a brokerage commission. That would mean you'd have to add it to the cost basis of the investment and it would reduce your gain or increase your loss on the sale of the stock, bond, etc.
Late filing penalties for S corporations, partnerships, LLCs . . . For most returns the penalty for late filing is based on the tax that's due. But what about returns where no tax is due? Here the penalties can be worse. In the case of a partnership, the penalty is $50 for each month or part of a month (for a maximum of 5 months) the failure continues, multiplied by the total number of partners. If the partnership has 4 partners and you're 6 months late, the penalty would be $1,000. There's also a penalty for each failure to furnish a Schedule K-1 to a partner. That penalty is $50 for each K-1. If the requirement to report correct information is intentionally disregarded, each $50 penalty is increased to $100 or, if greater, 10% of the total amount required to be reported. Don't forget, an LLC with more than one member is generally treated as a partnership. (Certain small partnerships can escape this penalty; check with your tax advisor.) The rules are slightly different for an S corporation. The rules with respect to the K-1 penalties are the same, but the minimum penalty for filing a return more than 60 days late is the smaller of the tax due or $100.