News On The Tax Front--The latest tax news.
Placed in Service--When must you start depreciation (or take the Sec. 179 expense deduction)? The answer is important and not always obvious.
Doing Business in Multiple States--How do you deal with state income taxes if you do business in more than one state? Here's a primer.
In Brief:--Tax, business, and personal finance tips.
Previously Reported In Daily Update
You can avoid the substantial understatement penalty if you can show you relied on your accountant, tax preparer, attorney, or similar professional in the preparation of your return. In John C. Archer and Nancy M. Archer (T.C. Memo. 2000-166) the taxpayers did not show to the Court's satisfaction that they provided their accountant with complete and accurate information. Furthermore they did not show that the error on the return was a result of the accountant's mistake.
In Eldon R. Kenseth and Susan M. Kenseth (114 TC--, No. 26) the Tax Court has held that the taxpayers were taxable on the full award of a settlement of a lawsuit, despite the fact that they had agreed to a contingent fee arrangement with their attorney. Thus, they had to report the full amount of the settlement as income. They could, of course, deduct the payment as a miscellaneous itemized deduction. The tax consequences, however, can be significantly different, particularly in the case of a large settlement. Talk to your attorney and your tax advisor. The outcome can depend on state law and where you live.
You may be entitled to a Section 1244 deduction if stock in your S corporation becomes worthless. You may also be entitled to a nonbusiness bad debt deduction, and a long-term capital loss. But you're going to have to prove your basis in the stock you hold. In Angelo F. DeJoy (T.C. Memo. 2000-162) the taxpayer was not able to show that amounts he advanced several wholly owned corporations were not repaid. Thus, the Court assumed they were repaid and required the amounts to be subtracted from his basis. The Court also noted that the fact that the businesses were not longer operating did not mean the stock in the corporations was worthless.
In Internal Revenue News Release IR-2000-31 the IRS announced that it will no longer accept paper returns in the 1040PC format after the 2000 processing year. Instead, the IRS wants taxpayers to e-file returns.
What you call it isn't as important as what it really is. That's what the Tax Court held in Marilyn J. Baker (T.C. Memo. 2000-164) in deciding that the payments were alimony and includible in the taxpayer's income, even though the clause specifying the payments was included under the title "Property Settlement" in the divorce agreement.
Some tax shelter cases are still alive. In Durham Farms #1, J.V., Gary L. Blackburn, Tax Matters Partner, et al. (T.C. Memo. 2000-150) the case involved almost all the classic tax shelter items of a cattle breeding partnership. The issues lost included deductions for guaranteed payments to a related party, the fair market value of cattle sold to the partnership, the validity of interest payments, and a deduction for accounting and tax return preparation fees.
The general rule is that if you pay the premium on disability insurance and proceeds you receive are not taxable. If your employer pays the premiums, payments are taxable. Worker's compensation and some similar payments are an exception. That is, if the benefits are based on the nature of the injury (e.g., $50,000 for the loss of an arm) and not on the income lost, such as is the case for worker's compensation. In Asa Eugene Pearson (T.C. Memo. 2000-160) the Court found that the payments the taxpayer received were based on his length of service and the premiums for the policy were paid by the employer. It found the benefits fully taxable.
We've said it before. Alimony payments are deductible; child support isn't. In Randolph John Beale (T.C. Memo. 2000-158) the taxpayer was able to show that payments to one of his ex-wives was deductible as alimony because the divorce agreement stipulated that the payments were deductible by the husband and income to the wife. However, payments to a second ex-wife were not deductible since he did not show the divorce agreement to the Court.
If you're self-employed and you want to deduct traveling expenses to and from a job site, you must show the location of your principal place of business. In Randolph John Beale (T.C. Memo. 2000-158) the taxpayer could not prove that his home office was his principal place of business. Thus, the Court held that travel to clients was a nondeductible commuting expense.
The IRS is always on the lookout for transactions between a shareholder and a C corporation. There's a good chance the IRS can find the transaction was not at arms' length and that a constructive dividend is involved. That would mean taxable income for the shareholder, but no deduction for the corporation. The best of both worlds, for the government. And the IRS usually wins these cases. But not in James H. Japhet (T.C. Memo. 2000-157). The corporation sold an apartment building to it's sole shareholder. The shareholder had an appraisal that the Court found satisfactory. The Court sided with the taxpayer, finding no constructive dividend.
In Fredie Lynn Charlton (114 TC--, No. 22) the Court found the taxpayer did not qualify for innocent spouse treatment. The husband had reason to know of his wife's understatement of income. However, the Court found that he qualified for relief under Sec. 6015(c) because the IRS did not prove that he had actual knowledge.
In Fredie Lynn Charlton (114 TC--, No. 22) the Court sided with the IRS in disallowing travel, supplies, utility and other expenses associated with a rental activity. The costs were incurred over several years as the taxpayers readied the property for guests. Thus, the expenses were nondeductible start-up costs.
The IRS has issued final regulations with respect to the "solely for voting stock requirement" under Section 368(a)(1)(C) dealing with corporate mergers. The regulations provide that a prior acquisition of a target corporation's stock by an acquiring corporation generally will not prevent the solely for voting stock requirement of the law from being satisfied.
A report recently released by the Joint Committee on Taxation showed that requests from states to the IRS for information increased almost 10 fold in 1999 from the 1998 amounts.
The IRS has just released Publication 969, Medical Savings Accounts.
In an IRS Technical Assistance release (ITA 200022050) the IRS held that payments the state of North Carolina made to assist low-income homeowners in replacing, repairing, or rehabilitating their homes damaged by floods as a result of Hurricane Floyd could be excluded from income. However, homeowners who receive or benefit from payments under this program may be required to include an amount in income if they previously deducted the amount of the loss to which the payment relates.
If you set up a money-purchase type pension plan, you must fund the plan at the stated percentage rate each year. In Phillip M. Wenger, C.P.A., a Sole Proprietor (T.C. Memo. 2000-156) the taxpayer didn't meet the minimum funding standard for the plan within the required time limit. The taxpayer made the contribution by the tax return's extended due date, but not with the 8-1/2 month period required under Sec. 412. The Court found the taxpayer liable for the 10% excise tax.
In many lawsuits attorneys are rewarded for their efforts based on a percentage of the award. In Willie Mae Barlow- Davis (2000-1 USTC 50,431; U.S. Court of Appeals, 11th Circuit) the IRS claimed that the entire settlement in a lawsuit was taxable income to the taxpayer and that the half of the $6 million settlement that went to the attorneys was deductible. The IRS reasoned that the contingency fee arrangement fit the open transaction doctrine. The Court sided with the taxpayer, finding that the attorneys' shares would be excludable from income.
You've got two other partners in your business. Each of you have a 1/3 interest. You failed to deposit the employment taxes. Who's liable? Each of you is jointly and severally liable. That means the IRS can come after all of you or just one of you. In In re H.L. Sanderson and Virginia R. Sanderson (2000-1 USTC 50,405; U.S. Bankruptcy Court, East. Dist. N.C.) the Court held that, while the IRS abated the husband's liability for the taxes, the Service could now assess the 100% penalty against the wife, the only remaining responsible person.
In Ljupco Ristovski (2000-1 USTC 50,409; U.S. Court of Appeals, 6th Circuit) the taxpayer was found to have received cash advances from the sale of scrap that he did not report as income. The Court found the underreporting was willful, in light of the fact that he was involved in the company's finances, and requested that the payments be made in amounts smaller than $10,000 so as to avoid the cash reporting requirements.
If you're considering the purchase of another business, buying back stock from current shareholders, fending off a hostile takeover, etc. you've got to evaluate all expenses associated with such actions. Many buyout, acquisition and financing costs are not deductible. In In re Hillsborough Holdings Corporation, et al., (2000-1 USTC 50,420; U.S. Bankruptcy Court, Mid. Dist. Fla., Tampa Div.) the Court disallowed a number of claimed deductions including advertising and public relations expenses, legal fees, etc.
In order to accrue an expense for tax purposes, you must pass the all events test. Basically, that means all the events that fix the amount of the liability must have occurred. In Exxon Mobil Corporation and Affiliated Companies (114 TC--, No. 20) the taxpayer tried to accrue the cost of dismantling and removing oil rigs and restoring the land at the time the rigs were constructed. The Court held that the costs were not sufficiently fixed. On the other hand, the Court did allow the company to accrue certain other, related, obligations that were common industry events and which could be reasonably estimated. CAUTION. The outcome of such situations depend heavily on the facts and circumstances. The important point to keep in mind is that book accounting treatment doesn't necessarily carry over to tax treatment.
In Mike Amini (T.C. Memo. 2000-152) the Tax Court found that the IRS correctly reconstructed the taxpayer's income using the bank deposits method. The taxpayer argued that certain deposits were from an inheritance, but offered no proof. The Court found the amounts were taxable income from the embezzlement of funds from his job. The fact that he pleaded guilty to embezzlement at a criminal proceeding didn't help his case.
In Randall Mark Jacobson (T.C. Memo. 2000-154) the IRS claimed that the "return received" date that was stamped on the transcripts bore no relationship to the date the return was received. The Tax Court didn't buy it. The taxpayers showed that they filed extensions and made tax payments on time. Moreover, testimony by an IRS agent indicated that the return received date on materials is the date it is received.
Someone once said "the devil is in the details". That's certainly true when it comes to tax law. Buying an auto, office or shop equipment, or real estate for your business and starting depreciation would seem like it should be simple. And it generally is. But there are exceptions. You can only start depreciation (or take the Sec. 179 expense election) when the property is "placed in service".
The IRS rules state that property is first palced in service for depreciation purposes when it is placed in a condition or state of readiness and availability for a specifically assigned function, whether in a trade or business, in the production of income, or in a personal activity. Buy a calculator, desk, or personal computer for general office work and there shouldn't be any question that the asset is available for its specifically assigned function on the day it arrives in your office. It doesn't matter that you don't open the box until 3 months later, well into the next tax year. The equipment was available for use, so it's considered placed in service.
Things get more complicated if there's a question as to the asset's availability for use. For example, you purchase a new machine for the shop. It's delivered on December 15th, 2000. But in order to use the machine you've got to run a special electric line and a factory technician has to align and test the machine. He doesn't arrive at your shop until January 4th. The machine is considered placed in service in 2001 and you can't take the expense election or begin depreciation until that time.
On the other hand, the IRS regulations give an example of a farm tractor that's delivered in December. The tractor is ready for use, but because it's for preparing the soil and for planting, it's not put to use until the following spring. In this case, it's considered placed in service in December. The fact that the unit wasn't used because of some outside factor isn't determining. The unit was available for use.
In a revenue ruling (Rev. Rul. 84-85) the IRS identified five critical factors in determining when an asset was placed in service. The factors are:
1. Permits and licenses. Basically, you must have all the permits and licenses necessary to use the asset. While this doesn't apply to all assets (the revenue ruling involved an electric generating plant), it can be critical in some cases. For example, you can't claim a truck was placed in service if it hasn't been registered. Nor could a building be in service if you don't have a certificate of occupancy.
2. Critical preoperational testing. Again, this may or may not be a factor. In the case of complex machinery or equipment that must be aligned or tested (particularly if it requires factory or other certified technicians) before it can be used in production, the failure to pass this phase would mean the equipment has not been placed in service.
3. Control of facility. When a plant is constructed or complex machinery installed, it's not unusual for the contractor to retain control of the plant or equipment until final testing. In fact, construction or installation contracts can require that the builder or manufacturer is responsible for the facility until operational testing has been completed, the architect has checked the construction, etc. If you don't have legal title, you can't start depreciation.
4. Synchronization into the power grid. Since this revenue ruling addressed a particular situation, an electric generating plant, this requirement obviously won't apply to most businesses.
5. Daily or regular operation of the facility. The facility or equipment must be able to operate on a regular basis. That means not only must the equipment or facility be able to operate in its assigned function in theory, it must also be able to do so in practice. Thus, the employees must be able to operate it and any supporting facilities must be running.
The last requirement is the one that could prove the stumbling block for many taxpayers. The requirement doesn't mean it has to run at its rated output. That is, the machine may be designed to produce 5,000 units per hour, but at startup it only produces 1,000. That's acceptable. However, in one case a facility was designed to produce ethanol at 198.2 proof. The Court found it was not in a condition of readiness for its assigned function until it reached that level of proof (Valley Natural Fuels, T.C. Memo. 1994-341).
In another case (Noell, 66 T.C. 729) the Court held that a new airport runway was not placed in service until it was paved and available for regular use, even though some pilots occasionally took the risk and used the rocky strip for landings prior to the runway's completion.
Courts have also held that in the case of an integrated facility, components are not considered placed in service separately from the system of which they are an essential part. An individual component, incapable of contributing to the system in isolation, is not in service until the entire system reaches a condition of readiness and availability for its assigned function. That could mean that machinery at the end of a production line isn't placed in service before other, essential equipment before it in the line is working. In some cases, that rule could extend to a building. Some buildings can't be separated from the equipment they house. That's often the situation with mills where the building is designed around the equipment. The building is replaced when the equipment is replaced.
Even if property is available for use, it's not considered placed in service if business has not begun. In Hawaiian Independent Refinery, Inc. (697 F.2d 1063) operational equipment purchased for a new business enterprise that had not yet begun operation was not in a condition or state of readiness and availability for its specifically assigned function until the business was functioning as a going concern. By extension, in Piggly Wiggly Southern, Inc. (84 T.C. 739) the Tax Court held that refrigeration equipment acquired for new supermarkets was not placed in service until they were open for business. On the other hand, equipment for remodeled stores was placed in service when purchased.
The placed in service question can turn on whether or not your employees can operate the equipment. In Siskiyou Communication, Inc. (T.C. Memo. 1990-429) the taxpayer's digital telephone switching equipment had been fully installed and it was capable of performing its designed function. However, the employee training was not completed until the following year. The Tax Court did not agree with the taxpayer's argument that depreciation should have been started in the earlier year because the equipment was physically capable of operating. The Court stated that if the employees did not know how to operate the new equipment, it was useless until they learned. In a similar situation the IRS held (in Field Service Advice) that a newspaper could not depreciate presses that were installed and tested by the manufacturer. The employees were on strike at the time and contracts precluded the use of management or employees of the vendor to run the presses. After testing the company drained the ink and mothballed the presses.
On the other hand, the IRS has said that depreciation can be started on replacement parts for equipment when the parts are available for use. That is, they are in house and the equipment for which they were purchased is in service. And, you must continue to depreciate idle equipment until it is sold, scrapped or abandoned.
What about delaying the start of depreciation? You can't do that either. If the asset is placed in service in a year, you must begin depreciation in that year. If you want to delay depreciation, you may be able to change the facts. For example, ask the supplier not to ship the equipment until after the end of the year. Or create a situation where the asset won't meet the technical requirements of the placed in service rule. You might be able to take delivery of the components and make sure that employees aren't trained or the equipment installed by the factory technicians before the end of the year.
Normally, you want to start depreciating equipment as soon as possible to secure the cash flow benefits of the deduction. If that's your intention, don't wait until the last minute to place the order if the equipment needs special installation, testing, etc. It would be a shame to miss out by just a few days. But in some cases you may want to delay the start of depreciation. For example, your total qualifying purchases are usually minor each year, but you've got $38,000 of various items of equipment on order. You want to take the Section 179 expense election, but the limit is $20,000 (2000 amount) per year. If you get the entire $38,000 of equipment in one year, you'll have to depreciate the excess $18,000. Delay placing the equipment in service until next year and you can write off some of it next year. That will accelerate your writeoff and result in an overall saving.
The placed in service rule is important during the year as well as at the very end. There's a "quarter-year" convention for depreciation. Place more than 40% of your total tangible personal property (anything but real estate) purchases in service in the last quarter of the year and you'll have to use a special depreciation rule. That could result in an overall delay in depreciation deductions for the year. You may want to make sure you don't break the 40% threshold after the start of the last quarter.
Doing Business in Multiple States
What happens if you do business in more than one state? Your home state (the state in which you're incorporated or where you filed your LLC papers, etc.) generally wants to tax every dollar of income. But a foreign state (any other state where you do business) wants to tax the income earned in that state. Do you end up paying tax on the same income twice? Generally, no. We say generally because the way states handle the problem isn't uniform. Thus, just because you do 45% of your business in state A and 55% in your home state of B doesn't mean 45% of your income will be taxed in A and 55% in B. Depending on the rules in each state you may end up paying slightly more or less. Can you come out ahead, that is pay state tax on less than 100% of your income? While it depends on the states where you do business, there's a good chance you can, but you'll have to be sharp.
When do you have to file a tax return in a foreign state? That's a complicated question, and, as always, depends on the rules in that particular state. If you simply send goods into the state and don't have any employees working in that state, you probably won't have to file income or sales tax returns. If you send independent sales reps into the state, you should still be able to avoid filing income tax returns. If you have a sales office and take orders but the orders have to be approved at another office out of state, some states exempt you from filing income taxes. However, if you have property located in a state, or have employees in a state, or have some other similar connection you almost need to file. Talk to your accountant. Not filing can result in penalties, interest, and many other tax problems.
Sole Proprietorships
If you operate as a sole proprietorship and do business in more than one state, apportioning income is different than for a corporation, partnership, or LLC. Generally, you'll have to file a nonresident return in that state. You'll have to report all the income from your Schedule C and apportion it based on one or more factors. How you do so may depend on the state and the type of business. Some states allow you to apportion based on days worked in the state. That's fine if you're the only employee and do consulting type work. If your business is more complicated, you may have to keep the details of your sales in the state, expenses related to them, etc. This similar to separate accounting, discussed below. Since your state of residency will tax all your income, you can take a credit for taxes paid to any foreign state. That, in theory, should offset any double taxation.
Apportioning Corporate, Partnership, etc. Income
The states have developed a more formal approach to dealing with corporations, partnerships, etc. It's sometimes called the Massachusetts formula (where it was first introduced), but more commonly called the three-factor formula because it uses the company's sales, property, and payroll to apportion the income between states. While the general theory is almost universal, some states modify the formula in different ways. The concept is simple. You compute a percentage for sales based on your sales in a state to your total sales. Do the same for property and payroll. Add the percentages and divide by three. The result is your apportionment factor. Apply that factor to your pretax income for the year (after making any required adjustments to the income for the rules in that state) and that's your income reportable to the state.
Example--Madison Inc. is incorporated in Massachusetts but also does business in states A and B. State A uses a simple three-factor formula. Madison's total sales are $3,500,000; it's sales in A are $1,225,000. Thus, Madison's sales percentage for A is 35%. The value of all of Madison's property (furniture and fixtures, autos and trucks, buildings, inventory, etc.) is $900,000; the total property in A is $180,000. Madison's property percentage for A is 20%. Madison's total payroll is $1,000,000; its payroll in A is $400,000. Its payroll percentage is 40%. Adding the factors results and dividing by 3 results in an apportionment percentage of 31.67% ((40% + 20% + 35%)/3 = 31.66667%). Madison's pretax income for the year is $375,000 so Madison's income reportable to state A would be $118,763 ($375,000 X .3167).
As we said, the theory is simple. Unfortunately, not every state uses the exact same approach and, in practice, the rules are more complicated.
Before moving on to some of the details, there are some points to discuss. First, if one of the factors is missing, for example, you have no property anywhere, compute the other two factors, add them up and divide by two, not three. If you just have no property and/or payroll in the state, the amount for that state is zero. There's still a denominator so you still have the factor, but it's zero.
Second, some states weight one factor heavier than others. For example, some double weight the sales factor. That is, the sales factor is included twice and the total percentage is divided by four. Massachusetts is one state that uses that approach. That can result in additional taxes in that state if your sales percentage is higher than your other percentages. For example, you only have a sales office and two employees in state A. You've got a manufacturing plant in another state. But your sales to state A are very high. You'll pay a disproportionately high share of your income to that state.
Sales factor. Sales may include not only the sale of tangible personal property and receipts from the performance of services, it can also include rental and royalty income. Generally, where a sale is allocated depends on where delivery takes place. For example, your only connection with New York is that you have a service depot there. You count as sales any goods shipped to customers in the state. There are some exceptions to this rule, so check with your tax adviser.
If you're not subject to income tax in that state, most states consider the sale belongs to the state from where the goods are shipped. The same rules also applies to sales to the federal government. For example, your home state is A and that's where all sales originate from, but you make sales in B, C and D. However, your sales in C and D are done strictly by catalog and telephone. You have no office or property in the state, so you're not subject to income taxes there. Sales to C and D are considered to belong to your home state, A.
Tax Tip--Clearly, if you do business in more than one state, you've got to keep careful records of where goods are shipped or where services are performed. Your accounting software should be able to handle this. Make sure your employees input the information correctly.
In the case of services, you allocate sales to the state where the services take place.
Property. Property consists of tangible personal property such as furniture and fixtures, machinery and equipment, computers, etc. and real estate such as land and buildings. Intangible property (bank accounts, stocks, etc.) is generally excluded. You can't escape by renting property. Every state has a way of including rented personal property and real estate in the factor, usually by taking the annual rent and multiplying by 8. Most states use an average of the beginning and ending values for property. Thus, even if you don't have any property in the state on January 1, but do have some at the end of the year, you'll have to include 1/2 of the year-end amount in your property factor.
Inventory is included as part of your total property and property in a state, but the rules vary on how inventory in transit must be counted.
Example--Madison Inc. has a total of $200,000 in personal property and inventory at the beginning of 2000; $250,000 at the end of the year. In most states it would have $225,000 of total property for the year.
Example--Madison Inc. pays rent on buildings of $130,000 a year. Madison must include capitalized rent of $1,040,000 (8 times $130,000) in its property factor.
Property is generally valued at net book value. That is, cost less depreciation. New York allows taxpayers to make an election to value the property at fair market value. Massachusetts requires taxpayers to use original cost with no reduction for depreciation and can require monthly averaging (rather than annual) if necessary to properly reflect the average value of the property.
Payroll. This usually includes not only salaries and wages but also bonuses, commissions, etc. Some states include amounts paid to independent agents, room and meals (e.g. hotel managers), etc. As a starting point, consider anything that you've got to include on an employee's W-2 as wages or amounts reportable to the state on payroll returns as compensation.
In some cases deciding whether amounts paid to an employee are allocable to a state or not is easy. For example, a secretary who works only out of the Albany office in New York would have all her compensation allocated to New York. But what about an engineer who lives in Massachusetts and is based in Springfield, but spends a day a week in Albany? For New York purposes you only include employees regularly connected with or working out of an office or other place of business maintained in New York, no matter where the services of the employee is performed. Other states may take a different approach.
An employee's compensation is allocable to Massachusetts if any of the following apply:
Some states exclude the wages and compensation of general executive officers and amounts paid to directors.
Massachusetts requires taxpayers to compute the compensation on a cash basis, as reported for unemployment purposes. However, a taxpayer that uses the accrual method of accounting in computing taxable income may elect to use the accrual method in determining the total amount of compensation paid in Massachusetts during the year if a special election is made.
Tax Tip--If you've been following along, it should be pretty clear that you need to keep good records if you do business in more than one state. You'll need to track sales, payroll and the location of property. The job should be easier if you do your accounting on computer, as you should.Tax Tip--Special allocation rules apply to some industries. For example, truckers may use miles in the state instead of sales. If you have a business that really doesn't fit the mold, contact the state. You may be able to use a special allocation method. Talk to your tax adviser. You'll need a good reason.
Separate Accounting, Combined Returns and Unitary Theory
While most companies will apportion income using the above approach, many states allow you to use separate accounting. It's pretty much what it sounds like. You compute your net income based on the income and expenses in the state. Unless the operation in the state is almost a separate entity, this generally isn't easy. And it can be expensive. You'll have to allocate overhead, salaries of employees who work both in and out of the state, etc. Despite the problems, it can result in significant tax savings if the operations in the state produce little or no income and the state has a high tax rate.
Under the unitary theory a corporation and all its subsidiaries (or entities under common control) should be taxed in a state because each entity is dependent, at least to some extent, on each other. That's true even if the parent or a subsidiary has no presence in the state. For example, Madison Inc. is the parent of Chatham Inc. and Columbia Inc. Madison makes computers, but has no operations in state A. Chatham is Madison's sales arm and has an office and employees and makes sales in state A. Columbia installs and repairs computers, primarily those manufactured by Madison, and has operations in state A. Clearly Chatham and Columbia will have to file income tax returns in A, but under the unitary theory so will Madison.
The return that's filed is a combined or consolidated return with the income and expenses of all three entities, Madison, Chatham, and Columbia. The sales, property, and payroll of all three are used in determining the total sales, property and payroll for use in the apportionment percentage. Thus, while Madison's income is included, because it has no sales, property or payroll in the state, it reduces the apportionment percentage. In theory, the result should be equitable. Whether or not that's true in practice depends on a number of factors including the tax rate in the state, the sales in the state, the profitability of the various entities, etc. In the example above, if Madison is not as profitable as Chatham and Columbia, the group's tax in the state may be lower than if only Chatham and Columbia filed returns. If that's the case, you may want to elect to file a combined return, even if not required. Work through the numbers. However, once you begin filing a combined return, you'll probably have to continue doing so.
Other Points
Many states impose a franchise tax as well as an income tax. The franchise tax is based on the property used by the business. Most states that have such a tax use the same factor for apportioning income to apportion the franchise tax.
When doing your tax return not all income is subject to apportionment. Certain items of income such as capital gains on the sale of property should be allocated to the state in which the property is located. Check the rules in the states you do business in.
Just because you have sales in another state doesn't guarantee that you can apportion some of your income to that state. Many states subscribe to the throwback rule. The theory is, even if you have sales in another state if that state doesn't tax the income, the income belongs to your home state. For example, you have catalog sales in 10 states, but you only have employees and property in state A. State A will not allow you to apportion your income. Or, in addition to the catalog sales in those states, in state B you have a office where you have some minimum operations for monitoring catalog printing and distribution. Under the rules of state B you're not subject to tax there. You can't apportion your income in state A.
Tax Tip--In some cases it may make sense to establish a presence in a state just so you can allocate sales outside your home state. The higher the tax rate in your home state and the lower the tax rate in the other state, the more advantageous this becomes.
Many small businesses just don't file in other states even though they may have a presence there. That can be a big mistake. You may not be able to apportion income in your home state. That means paying tax there on your entire income. Should you be audited later in the other state(s) you could be forced to be tax on your apportioned income there, resulting in the same income being taxed twice.
If you do business as an S corporation or partnership (or LLC) the rules are generally very similar to a regular corporation. However, since the income of an S corporation or partnership is passed through to the owners, in most states there is no tax at the entity level (i.e., S corporation or partnership). Caution. At higher gross or net income levels, some states do impose a tax on the entity.
While personal income taxes have been lowered by many states, that hasn't been as true for corporations. State income taxes can cost you 5 to 8% or more of your pretax income. That's not insignificant. Some planning can save you substantial tax dollars. Talk to your tax adviser. But be careful. Not all accountants and tax professionals are as well versed in multistate taxation as they may be in the rules in their home state.
Previously Reported In Daily Update
Life insurance and estate taxes. . . Life insurance proceeds are free of both income and estate taxes, but only if the insured doesn't own and has no incidents of ownership in the policy. For example, your spouse takes out a policy on you, pays the premiums, etc. Should you die, the proceeds are tax free to her. There's a point many individuals overlook in tax planning. Should your spouse die first, the value of the policy will be part of her estate. If she leaves the policy to you, the marital deduction will mean there's no tax, but only if she leaves the policy to you. However, should you later die owning the policy, it will be included in your estate. Check your wills. This is one asset that you may want to leave to your children or other relatives. There may be other options. Talk to your financial planner or attorney.
Note same as cash . . . If you use the cash method of accounting (as many small businesses and almost all individuals do), and receive a note as payment, you have to report the amount as income when you receive the note. For example, a customer gives you a note in payment for your goods. The only requirement is that the maker of the note be solvent and responsible at the time the note is given.
Change orders . . . It's not unusual to change an original purchase order. While multiple change orders are not uncommon in a construction contract, they can also occur when ordering a factory equipment, services, or even a car. Your first order may specify certain equipment or work but before the work is completed or even started you've added, deleted, or changed items. More than likely there will be a change in the final cost. While you should do so even if there are no changes, the more changes you have, the more important it is to check the final invoice against the work done, the original purchase order, and the change orders. You want to make sure the work was done and that you've been billed correctly. An item may have been deleted, but you may still be billed for it. Or you may have substituted a cheaper item and still be billed for the more expensive one.
Test marketing . . . If you're testing a new product or marketing campaign, consider doing a preliminary test on existing customers. They're much more likely to buy. If they do buy don't break out the champagne. You may not be so lucky with strangers. But if you can't make a sale to existing customers, there's probably no reason to do a major test in the open market. Results are likely to be poor. And you've saved yourself the expense of a big test.
IRS Reorganizes . . . The IRS is changing it's approach to auditing businesses. The Large and Mid-Size Business Division has now begun operating. While it's aimed at businesses with more than $5 million in assets, its approach could be a model for the way the IRS will audit smaller businesses in the future. The new strategy will focus on assisting taxpayers with pre- filing services to avoid tax disputes, seek ways of identifying and resolving issues between the IRS and taxpayers early, use methods to reduce the cost and duration of IRS examinations, and use specialized industry managers to provide consistent and timely responses to tax issues. Be aware that the move to industry specialization has been going on for some time. That could be bad news for some taxpayers. The IRS has identified and attacked specific industry issues.
Gift to corporation creates tax problems . . . Making $10,000 annual gifts to relatives makes sense. There are no gift tax consequences, yet the gifts reduce your estate. But in order to qualify, the gift must be one of a "present interest". In a recent case (Lavonna J. Stinson;) the taxpayer sold farmland to a corporation owned by her children and grandchildren in return for a note. Over several years the taxpayer forgave a significant portion of the debt. The Court held that the forgiveness was a gift to a corporation which was a gift of a future interest to the shareholders. Under the law, a gift of a future interest does not qualify for the gift tax exclusion. Thus, the entire $147,000 forgiven was included in the taxpayer's estate. Don't take a chance on this happening. Get good advice before making anything but direct gifts of cash.
ISP Settlement Guidelines . . . ISP (Industry Specialization Program) is the Service's approach to auditing and addressing problems in specific industries. The IRS has just recently released settlement guidelines in a number of areas. These include:
Get that loan now . . . It's no secret that interest rates have risen significantly in the last few months. But getting a loan could soon become more expensive--or more difficult to get. Many banks are tightening requirements. That could add to the cost of a loan, or even prevent some small businesses from getting one at all. If you need capital, now is the time to get it. Don't think you can avoid the problem by leasing equipment. As interest rates rise, so will the cost of leasing.
Charitable contributions . . . It sounds like a good idea. You rent your vacation home during the season, but just after peak you've got a week vacancy. So you donate a week's use to your church for use in a raffle. Bad move--for two reasons. First, the use of the home is deemed personal, not business. That means you won't be able to deduct the expenses during that time. Second, you'll get no charitable contribution deduction. That's because the gift of the right to use property doesn't qualify as a deductible contribution.
Copyright 2000 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