Small Business Taxes & Management

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

IRS Attacking Abusive Employee Leasing Arrangements --The IRS is warning taxpayers against participating in certain offshore deferred compensation arrangements involving domestic and foreign employee leasing companies.

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

News On The Tax Front

Previously Reported In Daily Update

The IRS and officials of the Financial Crimes Enforcement Network (FinCEN) announced (IR-2003-48) they have signed a memorandum of agreement under which FinCEN delegates its enforcement authority for Foreign Bank and Financial Account reporting to the IRS. The agreement marks the latest step in the IRS effort to seek out people with undisclosed accounts overseas. In January, the IRS announced an initiative to encourage the voluntary disclosure of unreported income by people who have used offshore payment cards or other offshore financial arrangements improperly to avoid paying taxes. People have only until April 15, 2003 to apply for benefits of the Offshore Voluntary Compliance Initiative (OVCI). Under the Bank Secrecy Act, U.S. residents or a person in and doing business in the United States must file a report with the U.S. Treasury if he or she has a financial account in a foreign country with a value exceeding $10,000 at any time during the calendar year. Taxpayers comply with this law by noting the account on their tax return and by filing Form 90-22.1, the Foreign Bank and Financial Account Report (FBAR). Willfully failing to file an FBAR report can be punished under both civil and criminal law. Those seeking information by telephone should call: 215- 516-3537. In addition, a special e-mail address has been set up for taxpayers. All e-mail queries should be sent to vci@irs.gov.

The IRS has issued guidance in a question and answer format on the tax relief provided under Executive Order No. 12744 for U.S. military and support personnel involved in the military operations in the Arabian Peninsula Areas. See Notice 2003-21 (IRB 2003-17).

The Internal Revenue Service is reminding resident and non-resident aliens applying for an Individual Taxpayer Identification Number to use the newly revised Form W-7 beginning April 15. The new application form requests additional information. The application is available in both English and Spanish on the IRS Web site, IRS.gov. The English language version of Form W-7 is available at www.irs.gov/pub/irs-pdf/fw7.pdf. The Spanish language version, Form W-7(SP), is available at www.irs.gov/pub/irs-pdf/fw7sp.pdf. They are also available by calling the toll-free Forms and Publications order line at 1-800-829-3676. To ensure timely approval, ITIN applicants should make sure they are using the new form. Old application forms used after April 15 will be returned to the applicant. Along with their application, applicants must also submit documents proving their alien status and their identity. Individuals can mail the documentation to the Internal Revenue Service, Philadelphia Service Center, ITIN Unit, P. O. Box 447, Bensalem, PA 19020, process the application through an IRS authorized acceptance agent or submit their application at an IRS Taxpayer Assistance Center. The IRS issues the nine-digit numbers to individuals who must have a U.S. taxpayer identification number but who aren’t eligible for a Social Security number. ITINs are for tax purposes only and don’t affect immigration status, authorize work in the U.S. or provide eligibility for Social Security benefits or the Earned Income Tax Credit.

In Pacific Gas and Electric Company (2003-1 USTC 50,267; U.S. Court of Federal Claims) the Court held that the IRS could offset the refund interest the IRS paid in error against regardless of the fact that the statute of limitations had run.

Rev. Proc. 2003-34 (IRB 2003-18) modifies one of the terms and conditions under which the IRS grants approval of requests for changes in annual accounting periods filed under Rev. Proc. 2002-37 (IRB 2002-22), and Rev. Proc. 2002-39 (IRB 2002-22). Specifically, this revenue procedure modifies the term and condition under which taxpayers generally are prohibited from carrying back net operating losses (NOLs) and capital losses (CLs) generated in the short period necessary to effect the change. See section 6.08 of Rev. Proc. 2002-37 and section 5.04(6) of Rev. Proc. 2002-39.

The IRS has issued final regulations (T.D. 9052) providing guidance on the notification requirements under section 4980F of the Internal Revenue Code and section 204(h) of the Employee Retirement Income Security Act of 1974 (ERISA). Under these final regulations, a plan administrator must give notice of a plan amendment to certain plan participants and beneficiaries when the plan amendment provides for a significant reduction in the rate of future benefit accrual or the elimination or significant reduction in an early retirement benefit or retirement-type subsidy. These regulations affect retirement plan sponsors and administrators, participants in and beneficiaries of retirement plans, and employee organizations representing retirement plan participants.

You can exclude from income amounts received for damages received on account of physical injuries or sickness if the damages are nonpunitive. Other amounts received are generally taxable. In Ed and Patricia A. Montgomery (T.C. Memo. 2003-64) the Court found the award was for damages related to a breach of contract. The Court held no part of the award was excludable from the taxpayers' income. In the same case, the Court found that the activities of the taxpayers' S corporation were not engaged in with a profit-making motive. Expenses of the corporation in excess of the income were held to be nondeductible.

You may be able to deduct travel and meal expenses while away from home. Away from home is the operative phrase here. In William J. McNeill (T.C. Memo. 2003-65) the Court found that the taxpayer, an over-the-road truck driver, was on the road 360 days one year and 345 days another year. The Court held that because of the large number of days he was on the road, he had no principal place of business and, with only a small exception, did not incur substantial living expenses at a permanent residence. That meant that his travel expenses were not deductible.

Don't rely on oral agreements. That's good advice anytime. In the case of Robert M. Ullman (2003-1 USTC 50,262; U.S. Court of Appeals, 3rd Circuit) the taxpayer had an installment agreement with the IRS. He claimed that the IRS orally agreed to reduce his payments when his pension benefits were reduced. When his benefits were reduced at a later date, he cut his payments to the IRS without consulting the Service. The IRS terminated his installment agreement because he did not pay the required amount. The Court noted the law does not authorize the IRS to enter into oral agreements. Thus, even if the IRS did breach an oral agreement, the breach would not constitute a violation of the Internal Revenue Code.

Whether a new business operation constitutes an expansion of an existing business or a new or different business is important for several sections of the Internal Revenue Code. In Rev. Rul. 2003-38 (IRB 2003-17) the IRS held that a web site to sell shoes at retail on the internet by a shoe retailer that had operations in malls and other locations was not a new business but rather an expansion for purposes of Section 355. (Section 355 deals with the distribution of stock in a controlled corporation to its shareholders and the nonrecognition of gain or loss on the transaction.)

Haven't filed your return for 2000 or 1999 yet? Everyone knows you've got to file to get a refund. But what if you had taxes withheld? If you don't file, you'll lose the ability to claim a credit for those withheld taxes (or estimated payments) if you file later. For example, you had $5,000 withheld from your wages in 1998. You file the return later this year with a total liability of $4,500. Think you'll get a refund? Since you'll get no credit for the withholdings, you'll actually owe $4,500, plus interest and penalties. In Rodney L. Burr (2003-1 USTC 50,258; U.S. Court of Appeals, 4th Circuit) the Court sided with the Tax Court in holding that the taxpayer could not apply a credit from an overpayment from a year closed by the statue of limitations to his estimated tax liability for the following year. The Court noted that he did not claim the credit within time period.

Just because you take your case to District Court doesn't mean you're automatically entitled to a jury trial. In David T. Stewart and Marilyn S. Thompson (2003-1 USTC 50,261; U.S. District Court, West. Dist. Texas) the Court held that the law doesn't grant the right to a jury trial under Sec. 7403. Thus, the Court adjudicated the issue of government's argument that an alleged fraudulent transfer of real property should be voided.

The IRS has created a new section on its web site containing important information to help ensure members of the U.S. Armed Forces serving in a combat zone get all of the tax benefits available to them. ] The new information is available on the front page of IRS.gov by clicking on "Armed Forces Tax Benefits." The new section highlights several special tax provisions that apply to those in combat, which can include extensions for filing tax returns and paying taxes and exclusion of some military pay from taxes. The site contains questions and answers on exclusions, extensions, and other tax benefits, IRS Publication 3, Armed Forces' Tax Guide, IRS news releases and notices and a special e-mail address for members of the U.S. Armed Forces, their spouses and agents which can be used to notify the IRS about someone serving in a combat zone. Generally, enlistees up to warrant officers exclude all their military pay received for military service in a combat zone. For commissioned officers, the monthly exclusion is capped at the highest enlisted pay, plus any hostile fire or imminent danger pay received. For 2002, this limit was $5,532.90 and for 2003, it is $5,882.70. Amounts excluded from gross income are not subject to federal income tax. In addition, the IRS automatically extends the deadline for filing returns, paying taxes, and filing claims for refund until at least 180 days from the last day of qualifying combat zone service, or the last day of any continuous qualified hospitalization for injury from the combat zone. When filing returns, mark "Combat Zone" at the top of the form along with the date of deployment. Correspondence to the IRS should include the name, date of birth, and date of deployment of the service member. (IR-2003-43 and FS-2003-11)

The IRS likes to recharacterize debt of a C corporation as equity. If it succeeds, the "interest" payments would not be deductible and both the interest and principal payments would be taxable to the shareholders as dividends. The IRS often wins in such situations for a number of reasons. However, in Delta Plastics, Inc. (T.C. Memo. 2003-54) the corporation was able to show the Court that the amounts received from the investors was true debt and not equity capital. Of the 10 factors (thin capitalization, repayments, intent of parties, etc.) that the courts usually examine, the Court here found that 8 applied. When analyzing and weighing the factors, the Court found they indicated the advances were debt, not equity.

Rev. Proc. 2003-33 (IRB 2003-16) grants certain taxpayers an automatic extension of time (pursuant to Sec. 301-9100-3) to file elections on Form 8023, Elections Under Section 338 for Corporations Making Qualified Stock Purchases under Section 338. A request for an automatic extension of time under this revenue procedure is the exclusive procedure available for obtaining an extension to file an election under Sec. 338 if all persons required to file Form 8023 can make the representations and submit the affidavits described in the revenue procedure. In other cases, an extension of time to file may be obtained through a letter ruling filed in accordance with Rev. Proc. 2003-1 (IRB 2003-1).

You can't undo a divorce decree, at least not in Tax Court. In Gloria M. Stark (T.C. Memo. 2003-47) the taxpayer argued her divorce was invalid and, therefore, amounts received as alimony should not be taxable. The Court noted that her home state had refused to overturn her divorce judgment and the Tax Court had to follow state law.

If you're not taking a salary from your S corporation, you'd better start. In a series of six cases (Veterinary Surgical Consultants, P.C., T.C. Memo. 2003-48; Mike J. Graham Trucking, Inc., T.C. Memo. 2003-49; Superior Proside, Inc., T.C. Memo. 2003-50; Specialty Transport and Delivery Services, Inc., T.C. Memo. 2003-51; Nu-Look Design, Inc., T.C. Memo. 2003-52; and Water-Pure Systems, Inc., T.C. Memo. 2003-53) the Tax Court held that president/owners of the corporations were employees. In addition, the taxpayers could not avail themselves of the safe harbor protection of Section 530 of the Revenue Act of 1978.

You can deduct margin interest as investment interest up to the amount of your net investment income (generally, interest, dividends and short-term capital gains) for the year. Any excess can be carried forward and used in future years, subject to the same rules. In Claudia J. Miner (T.C. Memo. 2003-39) the IRS claimed that the taxpayer could not deduct margin interest because she was an investor and not a trader, and thus the margin interest is not properly allocable to a trade or business. The Court disagreed that the taxpayer's status as an investor or trader determines whether she may deduct margin interest. The taxpayer contended that the notices of deficiency are not entitled to the presumption of correctness, and that IRS bears the burden of going forward to establish the existence and amounts of the deficiencies because Service's determinations were arbitrary. The Court did not agree.

If you don't have adequate books and records, the IRS can reconstruct your income using any of several methods. In the case of Bradley M. Cohen and Kathy A. Cohen (T.C. Memo. 2003-42) the Court said that when a taxpayer fails to maintain these records, the IRS may determine income under the bank deposits method. A bank deposit is prima facie evidence of income. The bank deposits method of reconstruction assumes that all money deposited into a taxpayer's account is taxable income, unless the taxpayer can show a nontaxable source for the income. The taxpayer could not produce evidence of a nontaxable source for the deposits made to an S corporation's bank.

IRS Attacking Abusive Employee Leasing Arrangements

The IRS is warning taxpayers against participating in certain offshore deferred compensation arrangements involving domestic and foreign employee leasing companies.

Taxpayers who are current or past participants in such arrangements are encouraged to apply to participate in the Offshore Voluntary Compliance Initiative (OVCI) that IRS announced on January 14 of this year. Under OVCI, eligible taxpayers who step forward will not face civil fraud and information return penalties. However, taxpayers will still have to pay back taxes, interest and certain accuracy or delinquency penalties. That initiative expires on April 15, 2003.

Under the typical leasing arrangement, an individual taxpayer supposedly resigns from the current employer or professional corporation and signs an employment contract with an offshore employee leasing company. The offshore company indirectly leases the individual's services back to the original employer using one or more intermediaries. The individual performs the same services before and after entering into the leasing arrangement.

The details can be substantially more involved. The arrangement involves a series of steps involving domestic and foreign parties. First, taxpayer, an individual, purports to terminate taxpayer's existing employment relationship with a domestic corporation ("Service Recipient Corporation") that may be owned, either directly or indirectly, in whole or in part by the taxpayer. The taxpayer then purports to enter into an employment relationship with a foreign corporation ("Foreign Leasing Corporation") that is incorporated and managed in a country with which the United States has an income tax convention. Foreign Leasing Corporation purports to lease the right to taxpayer's services in the U.S. to a domestic corporation ("Domestic Leasing Corporation"). Domestic Leasing Corporation, in turn, purports to lease taxpayer's services to Service Recipient Corporation.

Before entering into the arrangement, the taxpayer has little or no business relationship either with Foreign Leasing Corporation or with Domestic Leasing Corporation. After entering into the arrangement, taxpayer continues to provide substantially the same services for Service Recipient Corporation that Taxpayer provided before entering into the arrangement, and, thus, the interposition of Foreign Leasing Corporation and Domestic Leasing Corporation has no significant effect on taxpayer's performance of services for Service Recipient Corporation.

Service Recipient Corporation makes payments to Domestic Leasing Corporation for the taxpayer's services. Domestic Leasing Corporation makes payments to the taxpayer for Taxpayer's services in an amount substantially less than the amount paid to Domestic Leasing Corporation by Service Recipient Corporation. After deducting a fee for its participation in the arrangement, Domestic Leasing Corporation remits to Foreign Leasing Corporation, in return for taxpayer's services, the remainder of the amount paid to Domestic Leasing Corporation by Service Recipient Corporation.

Foreign Leasing Corporation deducts a fee from the amount paid by Domestic Leasing Corporation and typically credits the remainder to a notional account maintained on behalf of taxpayer. In certain cases, Foreign Leasing Corporation transfers the remainder to a trust ("Trust") for the benefit of taxpayer. Although the assets of Trust may be nominally subject to the claims of Foreign Leasing Corporation's creditors, it is typically difficult or impossible for creditors of Foreign Leasing Corporation, Domestic Leasing Corporation, or Service Recipient Corporation to reach the assets of Trust in the event of insolvency or bankruptcy of any of these entities.

The arrangement is often designed to provide taxpayer, either directly or indirectly, with explicit or implicit control over the amounts held on Taxpayer's behalf by Foreign Leasing Corporation or Trust. For example, the arrangement may permit or require Foreign Leasing Corporation to provide Taxpayer with a device, such as a credit or debit card, for paying personal, business, or professional expenses out of such amounts. As another example, the arrangement may permit the taxpayer to submit bills and receipts for payment or reimbursement from such amounts or to borrow from such amounts.

The taxpayer takes the reporting position that only the compensation actually paid to taxpayer by Domestic Leasing Corporation is currently includible in taxpayer's gross income and that amounts held by Foreign Leasing Corporation or Trust on taxpayer's behalf are not currently includible in taxpayer's gross income. These arrangements result in the avoidance and evasion of individual and corporate income and employment taxes. The arguments used by promoters of these arrangements to justify these tax benefits are inconsistent with numerous longstanding tax principles. The IRS intends to challenge the supposed tax benefits claimed for these arrangements and to assess appropriate interest and penalties.

The IRS cautioned taxpayers against this arrangement in a recent outreach project directed to medical professionals. A copy of the IRS alert from this project is available on the IRS web site at www.irs.gov-search for "employee leasing." Although this document was aimed at medical professionals, it is equally applicable to other taxpayers.

Notice 2003-22, describing the abusive employee leasing arrangement, is available on IRS.gov and will be published in Internal Revenue Bulletin 2003-18, dated May 5, 2003.

Information on OVCI is available on the IRS.gov home page link "Deadline Nears for Offshore Tax Evaders."

In Brief:

Previously Reported In Daily Update

Two last tax preparation tips . . . One, double check the address for mailing your federal and state returns. The address for your federal return may have changed--and it's different if you are getting a refund or have to pay. Two, there could be a difference between your federal and state returns if you're taking the 30% bonus depreciation that's allowed on your federal return. Some states are not allowing the additional depreciation, so you'll have to make an adjustment.

Time is running out . . . If you can't file on time, ask for an extension. The first, 4-month, federal extension is automatic. The first extension for most states is also automatic, but check the rules in your state. However, for both federal and state purposes, your taxes have to be fully paid by April 15 (later in some states), or you'll incur a penalty. Estimate your taxes as accurately as you can, add a safety factor if possible, complete the extension form and write a check. Can't pay? That's a bit more of a problem. There are some options. If you've got room on your credit card, you can pay by credit card. Two companies work with the IRS. The first is Official Payments Corporation at 1-800-2PAY-TAX (1-800-272-9829) or go to http://www.officialpayments.com/index.jsp. The second is Link2Gov Corporation at 1-888-PAY-1040 (1-888-729-1040) or go to https://www.pay1040.com/default.htm. (Both processors add a fee for the service.) Another option is applying for an IRS installment agreement. Go to http://www.irs.gov/individuals/page/0,,id=13428,00.html. That shouldn't be your first choice. Your request for an installment agreement will be automatically approved (there's a $43 fee) if you meet certain criteria. Specifically, during the last 5 years you must have timely filed all income tax returns and paid any tax due, not have entered into an installment agreement, must pay the full amount within 3 years and show that you can't pay the tax owed in full when due.

Roth vs. nondeductible IRA . . . This one's easy. If you have the option of contributing to a Roth or nondeductible IRA, pick the Roth. While you'll avoid current taxes on the earnings in both plans, the Roth earnings will be permanently tax free. Not so with the nondeductible IRA. In addition, you never have to withdraw amounts in a Roth, you can tap the funds without a penalty earlier, and you won't have to combine withdrawals with your deductible IRAs as you do with a nondeductible IRA. The only catch is that contributions are phased out for married couples filing jointly with modified AGI between $150,000 and $160,000 ($95,000 to $110,000 for single individuals).

Consider an extension . . . There's no real downside to requesting an extension. It doesn't increase your chances of being audited. On the other hand, getting an extension to file doesn't give you an extension to pay your taxes. The government wants its money--now. If you're not sure of one or more numbers, you're better off requesting an extension rather than filing on time and then having to file an amended return. The first extension (4 months) is automatic. Just carefully estimate what you owe. Even if you don't really need one, requesting an extension may make sense if you can take advantage of an election, option, etc. that will help your tax planning. For example, you may have converted an IRA to a Roth last year. You have until the extended due date of your return to undo it. You may also be able to extend the deadline for making contributions to your SEP or other plan. An extension may also give you the opportunity to see how your business will fare in 2003. That might affect the elections you make on your 2002 return. While the details may be different, most states use a similar approach.

Job hunting expenses deductible . . . You can deduct job hunting expenses as a miscellaneous itemized deduction on Schedule A of Form 1040. You can claim a deduction whether or not you land a new job. What's deductible? The cost of preparing, printing, and mailing a resume; payments for advice, such as assistance with resume preparation and interview coaching; travel to job interviews, etc. In the case of travel, the primary purpose of the trip must be the job interview. A side trip for pleasure isn't deductible. If you're reimbursed in full or in part, or you claim travel, meal, or entertainment expenses, you must complete Form 2106. The usual rules for deductions generally apply. Thus, you can't deduct the cost of a new suit, even if it's necessary to get the job; you can't deduct job hunting expenses that would put you in a new trade or business; you can't deduct such expenses if you were a student and are now applying for your first job; and you may not be able to deduct expenses if you've been out of work and not looking for an extended period of time.

Section 179 expense option doesn't apply to computer software . . . Using the Section 179 expense option you can write off up to $24,000 (for 2001 and 2002; $25,000 in subsequent years) in equipment acquired during the tax year. The law is pretty generous here, but there are some limitations. One is that the option only applies to tangible personal property. Unfortunately, computer software is classified as intangible property. That means you can't use the expense option.

Foreign bank accounts . . . The bottom of Schedule B of Form 1040 contains a section with two questions. You must answer the questions if you had over $1,500 in taxable interest or dividends or had a foreign bank account, or received a distribution from, or were a grantor of, or a transferor to, a foreign trust. Be sure to answer the questions correctly. It's especially important now that the IRS is stepping up investigations of foreign financial activities. Read the instructions. You've got to answer yes to the first question if you owned more than 50% of the stock in any corporation that owns one or more foreign bank accounts or you had signature authority over a financial account in a foreign country where the combined value of the accounts was more than $10,000 during the whole year.

Multiple businesses require multiple Schedule C's . . . If you operate more than one distinct business as a sole proprietorship, you've got to file a separate Schedule C for each one. For example, you operate a print shop and an auto parts retail store. You've got to file two separate Schedule C's.

How much do benefits add to your payroll costs? . . . Clearly, it's different for every business. Many small business owners provide very limited benefits. But you'll still have to add unemployment insurance, worker's compensation, the employer's portion of FICA, etc. to any base pay. Is there a rough number? Surveys generally report that benefits increase the base payroll cost between 30 and 40%. If you have a number of low-wage workers and you provide good health insurance coverage, the percentage could be much higher. But if you're doing a rough analysis, the 30-40% figure is a good rule of thumb.

Dependency exemption . . . Everyone knows you can claim the dependency exemption for your 12-year old son or daughter. That's obvious. But the law can get considerably more complicated. You may be able to claim a grown child, a brother, sister, father, mother or certain other relatives as dependents if they have less than $3,000 of gross income for the year and you provide over half of the dependent's support. (Income excludable from the person's gross income such as disability payments or social security is disregarded.) The gross income test doesn't apply if your child is either under age 19 at the close of the calendar year or is a full-time student under age 24 at the end of the year. There are many special rules (e.g., in the case of a married child), so you may have to do some research. IRS Publication 501 can help.