News On The Tax Front--The latest tax news.
Section 1244 Stock--S and C corporation shareholders can get special treatment if their investment turns sour, but only if you know the rules.
Group-Term Life Insurance For Employees--You can provide your employees with a fringe benefit that's deductible by you but tax free to the employee.
Estate Taxes--The Mechanics of Gifting --Here are 15 important points to review before making gifts to your children or other relatives.
Family Partnerships--You can cut your taxes by splitting income with your children and protect your assets by putting them in their names. Here's a rundown of the rules.
14 Reasons to Turn Down A Customer--Some customers you're better off without. Do any of your customers have these characteristics?
In Brief:--Tax, business, and personal finance tips.
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
Previously Reported In Daily Update
Legal expenses are only deductible if the issue they're associated with are noncapital in nature. For example, if the legal fees are to recover a bad debt, they're deductible immediately. On the other hand, if the fees were associated with the purchase of a building, they're capital in nature and part of the cost of the building. In Dana Corporation (99-1 USTC 50,411; U.S. Court of Appeals, Federal Circuit) the taxpayer tried to deduct a retainer paid to its law firm. The Court found that the retainer was offset by fees for services that would be nondeductible. Thus, it disallowed a deduction.
If June is soon to arrive, tax benefits are about to
expire. That's been the scenario for many years. Several tax credits are due to expire at the end of
June. They include:
Here's a case where the taxpayers were able to recover his attorney fees. The taxpayers bested the IRS in court on an issued concerning the deductibility of business interest. An IRS appeals officer had sided with the taxpayers, but the Associate Chief of the IRS Appeals Office refused to agree. The Court found that the IRS was not justified in its position. Junk Sik and Bok S. Lim; T.C. Memo. 1999-120.
If your records are inadequate the Court has some leeway in allowing deductions. It's called the Cohan rule after the songwriter. That's what happened in Hans C. Sherrer (T.C. Memo. 1999-122). While the taxpayer's testimony didn't help much, the Court found that he must have paid some of his expenses in cash. Note. While you may be able to keep a deduction, don't rely on it. Save it for an emergency.
IRS attacks on hobby losses aren't limited to horse breeding, auto racing or other recreational type activities. In William E. Flanagin and Barbara J. Flanagin (T.C. Memo. 1999-116) the taxpayer was a computer consultant who tried to deduct losses associated with writing programs for a mainframe computer. The Court found that the taxpayer lacked a profit motive. It noted that the activity was not operated in a business-like manner and the taxpayer had a long history of losses. It also noted the market for the software was very small. The Court made a distinction between the taxpayer's technical expertise and his knowledge about the business aspects of the computer software industry.
While there have been some important changes in the tax law in this area in recent years, it's still true that litigation settlements for pain and suffering aren't taxable. But, in the case of Allen Burditt II and Sarah Maunee S. Burditt (T.C. Memo. 1999-117) the Court found that the taxpayer drafted the settlement agreement, allocating a portion of the settlement to compensate the taxpayer for pain and suffering. The Court found that the agreement was not an arm's length one. Evidence showed that the agreement was clearly tax motivated. In addition, while the settlement agreement claimed mental anguish, the original claims were not. The Court held that the settlement was taxable. Note. Get good advice from competent tax counsel. Settlements can be substantial; a mistake here would be costly.
In a recent speech before the American Bar Association Tax Section a branch chief for the IRS said that the Service does not use the private letter ruling process to single out taxpayers for audit. However, the branch chief did say that the national office does inform the field agents of an adverse determination to give the field office a heads-up that the national office has researched particular issues affecting that taxpayer. Thus, despite the attempt at assurances from the IRS, you might want to think twice before requesting a letter ruling unless you expect a positive response.
The IRS has announced that it is working with a private contractor to develop an interactive installment agreement and offer-in-compromise application that could go up on the web by early summer. The new web program will be a self-help application that either taxpayers or practitioners can use. The IRS also said that it expects to create more self-help web applications.
As time goes on the outlook for meaningful tax legislation becomes cloudier, not clearer. While a number of bills have been introduced and there has been some consensus, new problems continue to appear. The latest is that the Congressional Budget Office is expected to officially announce that there will be no 'April surprise' (a big influx in revenue) as has happened in recent years. Republicans were hoping that another revenue surge would make tax cuts easier.
Destroying records too early can prove costly. In the case of Clair and Judith Worthington (T.C. Memo. 1999- 113) the taxpayers destroyed the very paperwork that could have documented their claim that they reported all their income. Without the records, the Court sided with the IRS. It proved even more costly because the Court disallowed bad debt deductions, holding that the associated income was never reported. For more details, see our article in the March 15, 1999 issue.
Some taxpayers are pretty aggressive when it comes to deductions, but this is one for the books. In Ralph Louis Vitale Jr. (T.C. Memo. 1999-131) the taxpayer was writing a book about brothels in Nevada. The IRS claimed he didn't have a profit motive and disallowed a number of deductions under the hobby loss rules. The Court didn't agree with the IRS. However, the taxpayer claimed a deduction for his visits to the brothels (where he paid the prostitutes in cash) as research expenses. The Court denied any deduction for those expenses, saying they were 'so personal in nature as to preclude deductibility.' It also disallowed many of the other deductions for lack of substantiation.
A kinder, friendlier IRS? In testimony before the Senate Small Business Committee that's what the new IRS Commissioner said the Service should be to small businesses. The Commissioner said the IRS must take the most basic steps to recognize the needs of small businesses, which account for 40% of the cash collected by the IRS. To that end the IRS is planning to cooperate with other agencies (such as the SBA), reduce reporting and filing burdens and improve education and training materials for small businesses.
In Rev. Proc. 99-21 the IRS issued guidelines describing the information required to be supplied to the IRS in order to request suspension of the period of limitations (under Sec. 6511) for claiming a credit or refund of tax due to an individual taxpayer's financial disability. Note. Normally, a taxpayer must file a claim for credit or refund of tax within 3 years after the date of filing a return or within 2 years after the date of payment of the tax, whichever period expires later. Under this provision, the period is extended if the taxpayer is unable to manage his or her financial affairs because of a medically determinable mental or physical impairment that meets certain criteria.
If you take your tax case to court and win, you may be able to recover your attorney's fees from the IRS. But just because you win, doesn't mean recovery is automatic. In Sidney Dishal and Anna Dishal (T.C. Memo. 1999-110) the taxpayer showed that his horse breeding and racing activity was for profit and not a hobby loss. He wasn't able to recover his litigation costs. The IRS was able to show it had a reasonable basis for its position. That allowed the IRS to get off the hook. The Court noted that several factors were indicative that the taxpayer's activities were not for profit.
You can now exclude up to $250,000 ($500,000 if married filing jointly) of the gain on the sale of your principal residence. That's a valuable tax break. But what if you transfer the property to a grantor trust? In a recent letter ruling (LR 199912026) the IRS has held that the grantor trust will be entitled to the same exclusion.
Almost every time there's a change in the tax laws for pension plans, your plan has to be amended. In Rev. Proc. 99-23 the IRS announced that it's extending the deadline for amending plans that are qualified under Sec. 401(a) and Sec. 403(a) for changes made by the Small Business Job Protection Act of 1996. The revenue procedure extends until the last day of the first plan year beginning after January 1, 2000 the remedial amendment period.
Alimony is deductible by the payer and taxable income to the recipient. A property settlement in a divorce does not have any income tax effects. One of the main differences is that alimony ends with the death of the recipient. If that's not clear, the payment will usually be considered a property settlement. And that's exactly what happened in the case of Gordon B. Cologne (T.C. Memo. 1999-102). The divorce settlement provided for the taxpayer to pay his ex-wife's income taxes. Under California law the obligation would continue after his wife's death.
No matter how valid your expenses are, without substantiation the IRS will disallow them and the courts will usually agree. In John D. Shea (112 TC--, No. 14) that's exactly what happened to a taxpayer who failed to keep a trip log and had no records of his entertainment expenditures or the business purpose.
In the same case as above (John D. Shea (112 TC--, No. 14)) the taxpayer successfully argued that he should be taxed on only 1/2 of the income from a consulting business. He claimed that since he lived in a community property state (California), the other 1/2 of his income belonged to his wife. The IRS cited IRC Sec. 66(b), but since the Service raised this argument late, it had the burden of proof and failed to carry it.
You don't have to file partnership papers for a partnership to exist for tax purposes. If several associates are operating a business together, it's usually clear a partnership is intended. On the other hand, cost-sharing arrangements (e.g., two businesses or business owners agree to share the costs of repaving a jointly used road or jointly own the road) aren't partnerships. In a recent technical advice memorandum (TAM 199907029) the IRS held that 4 individuals who owned an apartment building were doing business as a partnership. The venture filed a partnership return for a number of years. In addition, the IRS found that certain properties were assets of the partnership. The IRS cited the fact that the assets were reported on the partnership return balance sheet and depreciation was taken on the partnership return.
Individuals must pay a charitable contribution before the end of the year in order to take a deduction. A mere pledge won't work. On the other hand, corporations using the accrual method can take a deduction for a contribution approved by the board of directors if the contribution is actually paid within 2- 1/2 months of yearend. In a technical advice memorandum (TAM 199909039) the IRS ruled that special rule described above only applies to C (regular) corporations, not S corporations.
The tax law doesn't contain many give-aways, but section 1244 may be one of them. It allows an individual stockholder to deduct up to $50,000 ($100,000 on a joint return) of loss on qualified small business stock as an ordinary loss. Without this provision, such a loss would be deductible only as a capital loss and could only be used to offset capital gains or $3,000 of ordinary income per year. Thus, without this provision, if you had a $90,000 loss on small business stock and never had any offsetting gains, it would take 30 years to fully deduct the loss.
Another point. The maximum tax rate on long-term capital gains is 20%. If you use capital losses from the stock market to offset capital gains, those losses are saving taxes at only 20%. Section 1244 losses are saving taxes at your regular tax rate. That could be as high as 39.6%.
Claiming section 1244 benefits is easier today than ever. In the past, a taxpayer claiming a loss had to include specific documentation with the return. That requirement has been eliminated. Now, you must just have sufficient records to establish that you're entitled to the benefits of section 1244 (see below). Nonetheless, there are still a number of rules. Failure to follow them could prove very expensive. Here are the highlights of the law.
Definition of small business. The provision applies to a "small business corporation". That can be either an S or a regular (C) corporation. The "small" refers to the capitalization of the company. The amount of cash and other property received by the corporation as a contribution to capital and paid-in surplus generally cannot exceed $1 million. If additional capital is contributed, the company must designate which shares issued in the year the limitation is exceeded qualify as section 1244 stock. The designation must be made by the 15th day of the third month after the close of the year. Thus, for a calendar-year corporation, the designation must be made by March 15th.
$50,000 limit. As mentioned, the annual benefit is limited to $50,000 ($100,000 on a joint return). Any amount in excess of that is a capital loss.
Sale, exchange, or worthlessness. The benefit applies to a loss on the sale, exchange or worthlessness of the stock. Normally, taxpayers hold on to the bitter end, using the loss when the company goes bankrupt or is dissolved. In that case, your loss on the stock would effectively be limited to $50,000 ($100,000). However, if your investment is greater and you sell some stock in one year and additional stock in a later year, you may be able to secure a larger benefit.
Type of shareholder. The benefit is only available to an individual shareholder. If a partnership owns the stock, a partner can take the loss, but he must be able to prove he was a partner at the time the stock was issued and at the time of the loss. The benefit is not available to an estate or trust. That's an important point.
Stock issued by corporation. The stock must be issued directly from the corporation to the shareholder. You can't get the benefit if you buy it from another stockholder or acquire it through a merger. Some taxpayers have found a way around the problem by having the corporation redeem the shares and then issue them to a new holder. Check with your tax advisor before using this approach.
Shares must be issued. Stock must be issued for the capital contribution. Issuing stock certificates is a formality often ignored in a closely held corporation. That can be costly here. Additional contributions to capital will only qualify if stock is issued. For example, Madison Inc. issues 100 shares to Fred for $10,000 on the incorporation of the business. Two years later Fred contributes an additional $100,000 of equity capital but no shares are issued. While his total basis in Madison is $110,000, his section 1244 benefit is limited to $10,000.
Type of contribution. You can contribute cash or other property (equipment, etc.) in exchange for your shares, but not stock or securities. However if your basis (costs less any depreciation) in the property is more than it's fair market value at the time of contribution, your ordinary loss is limited. Check with your tax adviser if you're contributing property. You may want to get an appraisal of any assets before making the contribution.
Stock issued for services is not considered section 1244 stock. If the corporation and the service provider want to exchange stock for services, the corporation should pay the service provider in cash and have him contribute the cash to the business. Of course, that will result in taxable income.
Active business requirement. The corporation must be actively engaged in a trade or business. That means, for the most recent five tax years ending before the date the stock is dispose of, more than 50% of the corporation's gross receipts must be from sources other than rents, dividends, interest, royalties, etc.
Thin capitalization. Many owners of small, closely held corporations capitalize the business largely with debt. While there are some tax benefits, that could backfire here. The IRS could recharacterize the debt as equity. Since no shares were issued for that equity, it wouldn't qualify for section 1244 treatment. This is a tricky area; consult your tax adviser. It may be better to issue stock, at least up to the $50,000/$100,000 section 1244 limit.
Pre-November 7, 1978 stock. Special rules apply to stock issued before November 7, 1978. Check with your tax adviser.
Recordkeeping. The corporation should maintain the following records:
Finally, while you no longer need to include information with your return, if audited, you'll have to substantiate the address of the corporation that issued the stock, the manner in which the stock was acquired and the type and amount of consideration paid, and, if the stock was acquired for property, the fair market value of the property and your basis at that time. Keep in mind that if you're claiming such a loss, chances are better than even that the stock is worthless. Getting information from the company at that time may be difficult or impossible. It'll be worse if you're audited two years down the road. The benefits here are easy to secure and substantial; don't throw them away.
Group-Term Life Insurance For Employees
The best fringe benefit you can give your employees is one where the business gets a deduction, but your employees are not taxed on the benefit. There aren't too many more of these left, particularly ones that won't cost the company much. Group term life insurance is one of them. Most larger companies provide this benefit to their employees.
The approach is simple. You purchase term insurance for a group of employees. You can pay the full amount of the premium or require the employees to contribute a percentage of the total cost. Since this type of insurance is generally fairly cheap, most companies pay the full amount of the premium. While even small employers should be able to benefit from the group rate, larger employers will fare even better.
Employees may benefit in a second way. Since it's a group policy, employees that may be uninsurable under other circumstances will be covered, or older employees will be covered at a reasonable rate.
The tax benefits are not unlimited. Only the value of the first $50,000 of coverage is excludable. Coverage in excess of that amount is taxable to the employee, but at rates set by the IRS. Generally, those rates are advantageous. Better yet, the rates recently declined substantially. That makes it an even better deal.
Example--Fred Flood has $59,000 of group-term life insurance from Madison Inc. Madison pays all the premium. Fred is 41 years old. Based on the IRS table for his age the value of the coverage is $0.10 per month per $1,000 of coverage. Fred's excess coverage is $9,000. Assuming he's covered for the entire year, Madison would include $10.80 ($0.10 x 9 x 12 months) on Fred's W-2. The $10.80 is subject to withholding taxes, FICA and FUTA.
The table is broken down into 5-year brackets. For 1999 things are slightly more complicated. For coverage provided on or before June 30, 1999 you'll have to use the old rates. For coverage after June 30, the new rates apply.
Age Bracket Cost per $1,000 of Protection for one Month
After June 30, 1999 Before July 1, 1999
Under 25 $0.05 $0.08
25 to 29 .06 .08
30 to 34 .08 .09
35 to 39 .09 .11
40 to 44 .10 .17
45 to 49 .15 .29
50 to 54 .23 .48
55 to 59 .43 .75
60 to 64 .66 1.17
65 to 69 1.27 2.10
70 and above 2.06 3.76
Of course, nothing involving taxes is that simple. There
are some other rules and points you must consider.
Tax Tip--Even though the full amount is included on an owner's W-2, that's still better than paying the full amount of term life out of your own pocket. The benefits increase if the cost of coverage for you would be high. Consider that for $100,000 of coverage for a 54-year old male you'd have to include just $276 in your income. The actual cost of coverage could easily be twice that.
- No physical exam is required (a medical questionnaire is allowed).
- Coverage is provided to all full-time employees.
- Coverage must be provided either based on a uniform percentage of compensation or on the basis of brackets established by the insurer.
Setting up a group-term life insurance benefit program should be simple. Your insurer should have canned documents. Most of the requirements discussed above should be easy to meet. Moreover, this fringe benefit should provide plenty of bang for your buck. Providing $50,000 of coverage for an employee should be relatively cheap, yet he will probably perceive this benefit as very valuable. Of course, the younger the average age of your staff, the cheaper the premiums.
Estate Taxes-- The Mechanics of Gifting
On more than one occasion we've mentioned that probably the best way to save estate taxes is to make regular gifts that come under the $10,000 ($20,000 if you spouse joins in the gift) gift tax exclusion. Such gifts reduce your taxable estate, without affecting your unified gift/estate tax exclusion of $650,000 (1999 amount). You can generally gift almost any type of property--cash, artwork or collectibles, stock, real estate, etc.--but some property (e.g., cash, stock, securities) is easier to gift. While the mechanics of gifting is usually simple, there are some points you should keep in mind.
Don't take the advice below lightly. The marginal tax rates on gift/estate taxes reach 55% on a $3 million estate. Thus, if the IRS disallows $50,000 of gifts, that could cost your estate as much as $27,500. Even at the lowest estate tax levels ($650,000 currently), each gift dollar will save 37 cents in estate taxes. That's because only the first $650,000 (1999 amount) per individual escapes taxes.
Gift splitting. You can gift $10,000 annually to family members, friends, etc. tax free. Your spouse can do the same. Or you can elect to split the gift. For example, your wife decides to give $18,000 of jewelry to your daughter. The excess over the $10,000 limit would be subject to tax, but your wife can avoid any taxes if you agree to joint in the gift. Then, each of you will be deemed to have made gifts of $9,000.
Tax Tip--You've got to make an election to do so. That's done by filing a gift tax return (Form 706) by the due date (April 15th of the year following the gift).
Sham gift. You want to maximize your gifts so you and your spouse make a $20,000 gift of stock in your company to your daughter and another $20,000 gift to her husband. However, you never did like your son-in-law, so you force him to sign over his interest to your daughter. That's no a completed gift. The IRS will argue that you really made a $40,000 gift to your daughter. That would make $20,000 of the gift subject to tax.
Assignment of income. You can't simply give away the income to a piece of property. The donee must have a legal right to the income generally, that means gifting the property.
Competent donor and donee. If there's any question about the competency of either party, get legal assistance. You may also need a medical opinion to show the donor and/or donee was competent at the time of the gift.
Power of attorney. A person who has a power of attorney for someone can make gifts for that person. For example, your father gave your brother a power of attorney several years before he had a stroke. While in a coma, your brother makes gifts for your father of $10,000 to himself, you, and your bothers and sisters. The gifts should be considered legitimate gifts for tax purposes. In fact, that power of attorney could be very valuable if such a situation should occur. Talk to your tax advisor and attorney to insure you make no mistakes.
Intent to make a gift. There has to be a clear intent to make a gift. This usually isn't an issue, but you don't want to make a mistake here. When can such a situation arise? For example, your son borrows $10,000 from you for a downpayment on a house. He doesn't pay it back. For both gift and income tax purposes it would probably be better to have a loan agreement and forgive the amount of the note as a gift.
Irrevocable transfer. You must transfer legal title to the property and the transfer must be irrevocable. Go through the trouble of executing all the legal filings. If a deed or title transfer has to be recorded with the county clerk, do so. Retaining voting rights to stock in your company will make the gift incomplete. In the case of a life insurance policy, you still own the policy if you can change the beneficiaries, borrow against the policy, etc.
This is not the time to get cheap. If there are transfer costs (sales taxes, recording taxes, legal fees, etc.) don't try to get away cheap by avoiding them. Sign over stock certificates. Get legal assistance. You don't want to make an error that could make the gift incomplete.
There are some exceptions to the above rule. For example, you give property but with the stipulation that you'll get it back if the donee should die before you do. This is a gift, but not for full value.
The same is true of a gift of a remainder interest. For example, you give your children your vacation home, but with the proviso you can live in it until you die. Again, it's a gift, but not for full value. In both cases the value for gift tax purposes depends on IRS valuation tables.
Delivery of gift to donee. The donee generally must receive delivery of the gift. If the donee doesn't know he or she has been given a gift, they can't make use of the property and there's no completed gift.
Acceptance by the donee. This condition rarely comes up in practice. However, if the donee for some reason refuses the gift, you haven't make a completed gift.
Check cashed. If you're a procrastinator you may wait until December 31st of each year to make the gift to qualify for the annual exclusion. that could be a mistake. The gift is not complete until the check is paid, certified, or accepted by the donee. Why? Until that time you could revoke the gift.
Promissory note. This one is tricky. If the note is legally enforceable under state law, you should have a completed gift when the note is given to the donee. However, you're better off avoiding this approach.
Fair market value and basis. The fair market value at the time of the gift is used to compute the amount of the gift. On the other hand, the donee takes over your cost basis. For example, you bought 100 shares of Madison Inc. at $20 some years ago. It's now worth $100. You give the 100 shares to your daughter. The value of the gift is $10,000. That's the amount your estate will be reduced by. On the other hand, your daughter will take over your basis in the stock, $2,000. (She'll also take over your holding period.) Thus, if she sells the stock the next day for $10,000, she'll be liable for capital gains taxes on $8,000.
That's not necessarily a bad thing. You'll have saved at least $3,700 in estate taxes; she'll have to pay $1,600 (20% of $8,000) in capital gains taxes. She may owe less in taxes if she's in the 15% bracket.
Talk to your tax advisor about the best property to gift. You may be able to set up a win-win situation. For example, gifting stock in your business that the donee won't sell because he or she will be taking over the company some day.
Medical and educational expenses. There's no limit to the amount you can gift tax free to another party if the amount is used for their medical care or education. There are some restrictions here. You've got to pay the expense yourself. You can't write a check to your child and have him or her pay the expense. And only certain expenses qualify. In the case of educational expenses, only tuition qualifies. For medical care, only expenses that would be deductible and not covered by insurance. For example, rehab after a car crash should qualify; a tummy tuck won't.
This is an excellent way for grandparents to make substantial gifts. But discuss them with your tax advisor to make sure you're complying with all the rules.
Lifetime exemption/credit. Every individual is entitled to a lifetime unified estate and gift tax credit. For 1999 the credit is $211,300. That's equivalent to $650,000 of property. Most taxpayers don't make annual gifts that exceed the $10,000/$20,000 limitation. That means the full $650,000 is available on their death. However, there can be times when using up part or all of the exemption before death makes sense. For example, your assets are now worth several times more than the $650,000 exemption. You own lakefront property that's now valued at $100,000, but the lake will soon be closed to future development. When that happens the price of the property should easily triple in just 2 or 3 years. By gifting the property now you'll be essentially removing $300,000 from your estate. Your heirs will have to pay higher capital gains on any sale, but that will still be considerably less than estate taxes that effectively start at 37%. Other assets may also work, for example, an interest in your business. Be careful, however, there are special estate tax benefits for stock in a closely held business.
Valuation. Unless you're giving cash or marketable securities, get a competent appraisal. Again, no time to go cheap. Should your return be selected for audit, a good appraisal will be invaluable.
You can save money on appraisers if you gift similar property near the end of the year and then make another gift just after the beginning of the next year. For example, you make a gift of your company's stock in December, 1999 and another in January, 2000. While you should get an opinion for both gifts, the appraiser's fee for the second one should be nominal. In fact, he may decide the value hasn't changed.
If you're giving cash or property that's easily valued, you should be on safe ground. However, the trickier you get, the more you need professional help. Talk to your estate and tax advisors before proceeding. Keep in mind that state rules may be different and there are special federal penalties for over or under valuing property. That could add another 20% or 40% to the tax bite.
It would be nice to split the income of your business with your son and daughter who are in much lower tax brackets. Or to have your teen-age daughter rent you the construction equipment you use on your job. The income would be taxed at her lower rate and the assets kept out of your name. It can work, but you've got to follow the rules. We're not talking about family limited partnerships here. However, many of the same rules apply. And don't forget that in most cases an LLC is taxed as a partnership and, for federal tax purposes, the same rules apply.
Members of a family can be partners. However, family members (or any other person) will be recognized as partners only if one of the following requirements are met:
Example--Madison Co. partnership owns construction equipment that it rents both to a family owned business and to unrelated customers. Capital is a material income-producing factor (see below). You and your 14-year old daughter are equal partners. You'll probably have trouble convincing the IRS that your daughter has actual control. One way out is to have her interest managed by an independent trustee. Unfortunately, that can be expensive.
Example--Derry Co. partnership does computer consulting for small businesses. Capital is not a material factor. You and your 22-year old son who is in grad school are equal partners. The IRS will probably disregard all or part of the partnership allocation unless you can show that your son contributes significant or vital services to the business or contributed capital.
Tax Tip--One way to ratify the interest of a partner in a partnership where capital isn't important is for the partner to purchase the interest with his own funds.
In general, a minor child cannot be a partner unless he or she is shown to be competent to manage his own property and participate in the partnership activities. In addition, the use of the child's property or income for support for which a parent is legally responsible will be considered a use for the parent's benefit.
Capital is material. Capital is a material income- producing factor if a substantial part of the gross income of the business comes from the use of capital. Capital is ordinarily an important factor if the operation of the business requires substantial inventories or investments in plants, machinery, or equipment. On the other hand, capital isn't a material factor if the income of the business consists principally of fees, commissions, or other compensation for personal services performed by members or employees of the partnership.
Capital and profits interest. There are two types of interests in a partnership--a profits interest and a capital interest. A profits interest entitles the partner to share in the profits (or losses). A capital interest is an interest in the assets that is distributable to the partner if he or she withdraws from the partnership or the partnership liquidates. The mere right to share in earnings and profits is not a capital interest in the partnership.
While most partnership agreements call for the partners to have the same profits and capital interests, many do not. For example, Fred and Susan agree to form a partnership. Fred puts up the bulk of the capital but is unable to work full time in the business. Susan puts up less money, but works full time. Fred might have a 70% capital interest and a 40% profits interest while Susan has a 30% capital interest but a 60% profits interest. Incidentally, this is one of the important advantages of a partnership over other types of entities.
Gift of capital interest. If a family member (or any other person) receives a gift of a capital interest in a partnership in which capital is a material income-producing factor, the donee's distributive share of partnership income is limited. To figure the donee's share:
An interest purchased by one family member from another family member is considered a gift. For this purpose, family members include only spouses, ancestors, and lineal descendants (or a trust for the primary benefit of those persons).
Example--You sell 50% of your business to your son. The resulting partnership had a profit for $120,000. Capital is a material income-producing factor. You performed services worth $48,000, which is reasonable compensation, and your son performed no services. The $48,000 must be allocated to you as compensation. Of the remaining $72,000 of profit due to capital, at least 50%, or $36,000 must be allocated to you since you own a 50% capital interest. Your son's share of partnership profit cannot be more than $36,000.
Husband and wife partnership. If you and your spouse carry on a business together and share in the profits and losses, you may be partners whether or not you have a formal partnership agreement. You should report income or loss from the business on Form 1065 (Partnership Return), not on Schedule C. Each of you should report your respective share of self-employment income on Schedule SE (Self-Employment Tax).
A family partnership can offer considerable income-splitting opportunities while keeping fixed assets out of a corporation and transferring ownership for estate tax purposes. However, be careful not to run afoul of the rules. Get good tax advice before committing to any action.
14 Reasons to Turn Down A Customer
Unless you really need the cash, it sometimes makes sense to turn down a customer. There are some customers that you may be better off without. Here's a list of some telltale signs.
Look through the list. No one factor should determine your action. However, if a number of these items applies, you should take action. If he accounts for a relative small part of your business, you can start charging him for consultations, rework costs, etc. or, if money won't solve the problem, simply suggest that he go elsewhere. If he represents a substantial part of your business, take steps to reduce your reliance on him. Do it quickly. Use your best judgment. If you're unsure, talk to your accountant or financial advisor.
Previously Reported In Daily Update
Manufacturing versus repairing . . . Many states provide benefits for manufacturing. The benefits can include investment tax credits and sales tax exemptions for equipment purchased for use in the manufacturing process. But you've got to watch definitions carefully. In a recent New York state ruling a company refurbished CV (constant velocity) joints for cars. The state held that if the company rebuilt the part and put it on the shelf for inventory, they were engaged in manufacturing and equipment purchased for that purpose was exempt from sales tax. On the other hand, if they rebuilt a customer's part and returned the same part to him, they were in the business of repairing, not manufacturing. Check with your tax advisor.
Junk bonds riskier . . . For several years junk bonds haven't been such a bad investment. That may be changing. The default rate is increasing. Not rapidly, but it is a disturbing trend. Bonds that are maturing could be even riskier. If the issuer can't refinance, holders could be in big trouble. Remember, even though the economy as a whole appears to be doing very well, there are companies that are having problems. And, even if a company is profitable, it still could have cash flow difficulties. That's enough to trigger a default. If you're investing in individual bonds, be very careful. Your risk is less in a bond fund, but even a fund may not be the place for your children's college fund. Get good advice.
Credit card life insurance . . . Your credit card issuer may offer you life insurance that will pay off the balance on your bill should you die. That's not a good deal. The insurance is often about $0.75 per monthper $100 of balance. On a $1,000 balance that's $7.50. On an annual basis that would be $90. Unless you're a cropduster (using an airplane), a steeplejack, or in some other extremely hazardous profession, or your doctor has given you only a year to live, you can get life insurance much cheaper elsewhere. In fact, you might be able to buy it for not much more than a 1/10 of that. If you think you need such insurance it should be a warning that you should seek professional financial help.
State tax audit procedures . . . If you don't keep good records the IRS can reconstruct your income using a number of methods, such as your spending and your bank deposits. Many states have much broader powers, particularly when it comes to sales tax audits. If you're a retailer or a restaurant and your records are very poor a state auditor may base your sales on the observation method. For example, the auditor may observe your sales for a one or several days, then extrapolate the result over one or more years. If the day he picks happens to be particularly busy, you could be in trouble. Worse yet, if your records are poor, you may have little recourse.
IRS Publications updated . . . One of the best sources of practical information can generally be found in IRS publications. The explanations are usually without technical jargon and the examples generally represent real life situations. Unfortunately, the numerous law changes have taken their toll. Many of the publications have been revised, even after the recent year-end printing. Use caution and keep watching these pages. Publication 523 dealing with the sale of your home, was recently revised.
Capital gain rate not 20% . . . The maximum tax rate on capital gains isn't really 20%. The effective rate can be higher. Why? While the gain itself is taxed at only 20%, the gain increases your adjusted gross income (AGI) dollar for dollar. That affects your ability to deduct medical, miscellaneous itemized deductions, and casualty losses (since you must exceed a threshold based on AGI). It affects your overall itemized deductions, rental losses, etc. It will also affect your ability to take the child, education and certain other credits. Your AGI will also impact other tax items such as the exemption for the alternative minimum tax, Roth conversion and contributions, etc. What can you do? Talk to your tax adviser. If you have the option, depending on the situation, you might want to bunch your capital gains in one year or spread them out over several years. The best approach depends on the size of the gain and your total income.
Defined benefit plans . . . These types of plans can be particularly advantageous to older business owners. Why? The maximum contribution possible with a defined contribution plan is $30,000. For a defined benefit plan the contribution is limited to an amount necessary to fund the participant's maximum annual benefit. That annual benefit is limited to the lesser of $130,000 (1999) or 100% of the employee's average compensation for the highest-paid 3 consecutive years during which he or she was an active participant in the plan. Thus, while you may have straved during the formative years of your business, you may be collecting (or could be collecting) a high salary in the later years. For older owners that can require much larger contributions since there's less time to accumulate the amounts necessary to fund the plan. In fact, the maximum annual contribution could easily exceed $50,000 per year. That can also be a boon to a business owner who sells his business but has a consulting contract. He may be able to shelter a significant part of the payments. This is a complex area. Get good advice. Plan early. If you're less than 10 years from retirement, the benefits (and, therefore the contributions) are limited under a special formula.
Gifts . . . Cash that check that grandpa gave for Christmas before the end of the year. For gift and estate tax purposes, the check may not be considered a completed gift until cashed. The theory is that the gift can be revoked until then. That could mean that grandpa would lose out on a $10,000 gift tax exclusion for the year. Worse yet, the gift may be considered made in the following year. That could mean he'll be over the $10,000 limit and have to file a gift tax return. The situation could be even worse if grandpa is terminally ill. Rather than a year-end problem, this could cause a problem at any time if you don't cash the check before his death. In that case the amount could be included in his estate.
Credit cards . . . For a long time it's made more sense to make foreign purchases on a credit card, if possible. You generally get a better exchange rate than if you went to a bank and converted your dollars into the local currency. But be careful. Several card companies are increasing the fees they charge. In one case the fee will go from 1% (what most companies charge on foreign transactions) to 5%. That's quite a jump. Check with the banks that issued your cards. The solution may be as simple as taking most of your cards and leaving one or two at home.
Telephone costs . . . They can represent a substantial portion of your total costs. If you're a small business owner with several separate lines should consider the following: