News On The Tax Front--The latest tax news.
Out-Of-Pocket Expenses May Not Be Deductible--Most businessmen assume that most expenses should be immediately deductible. Well, sometimes an out-of-pocket expense can be classified as a loan.
Deducting Points on a Loan--In some cases points are deductible up front; sometimes the best you can do is amortize them. Only specific charges qualify as points.
Rental Deductions Disallowed--Sometimes innocent mistakes can result in disastrous tax consequences. Here's a situation where trying to fudge a little cost the taxpayers big money.
Phantom Partnerships--You may be in a partnership without even knowing it.
Home Office Deduction--How Much is it Worth?--How big a tax saving can a home office deduction generate? It depends on a number of factors. Here are some examples.
Current Yield vs. Yield To Maturity--There's an important difference.
In Brief:--Tax, business, and personal finance tips.
Previously Reported in Daily Update
The IRS has recently ruled (Rev. Rul. 99-28) that the cost of a stop-smoking program and the cost of prescription drugs designed to help with nicotine withdrawal are deductible as medical expenses. On the other hand, over-the-counter medications such as nicotine gum and patches that don't require a prescription aren't deductible. The costs of a smoking-cessation program are deductible whether or not the program is entered into on the advice of a physician.
Is another capital gains tax cut in the cards? That's one serious proposal on Capitol Hill. Capital gain tax cuts raise revenue because taxpayers sitting on large gains are more encouraged to sell when rates go down. Such a cut is also viewed as a tax reduction. In essence, lawmakers get the best of both worlds. We'll keep you posted.
In a recent speech IRS National Director of Specialty Taxes Thomas R. Hull said that the IRS doesn't want to penalize small business taxpayers who try to fix their year 2000 computer problems but fail to do so. The IRS is currently studying the issue and hopes to arrive at a solution by the end of September.
The IRS has reported it is using alternative methods to measure taxpayer compliance. Special TCMP audits were detailed audits of taxpayers (e.g., if you filed as married you might have had to produce a marriage certificate) where almost every part of the return was questioned. While not many taxpayers were selected, they were the most dreaded form of audit. They did provide valuable statistics on how taxpayers were complying with the rules. Congressional action has tabled these audits, and that's put the IRS in a difficult position. One approach it's recently tried is to send out notices to firms in industry groups explaining the rules. In one test the IRS notices resulted in a 50% self-correction rate.
If a debt you owe is canceled, the unpaid amount usually results in cancellation of debt income. There are some exceptions to the rule (insolvency and bankruptcy to name two). In Jerry Myers Johnson (T.C. Memo. 1999-162) the taxpayer tried to argue that the discharge of a mortgage should not be included in his income because he had no control over the events that led to the discharge. The Court did not agree. The amount was income, no matter what the circumstances.
If you're faced with an IRS claim that an activity is really a hobby and the losses should be disallowed, you might try to argue you're trying to start a business for your retirement. You may get a little sympathy, but the taxpayer in Joyce E. Hastings (T.C. Memo. 1999-167) didn't sway the Court. It noted years of losses, minimal income, and no attempt to cut expenses. In an unrelated matter, she was also assessed late filing penalties. She argued obligations of her practice (she was an attorney) and family illness were reasonable cause. The Court had no sympathy and noted that she had a history late filings.
In Notice 99-30 (I.R.B. 1999-22) the IRS has provided guidance on the tax relief provided for U.S. military and support personnel involved in the military operations in Yugoslavia, Albania, the Adriatic Sea and the Ionian Sea north of the 39th parallel. The area is treated as a qualified hazardous duty area as of March 24, 1999 (some provisions are effective as of April 19, 1999). Pay received while in such a zone is treated the same as if the taxpayer were in a combat zone and is generally excludable from income.
In Notice 99-31 (I.R.B. 1999-23) the Service informed taxpayers that the deadline for special reformations of charitable remainder unitrusts (CRUTs) will be extended from June 8, 1999 until June 30, 2000.
In IR-1999-48 the IRS announced it is now storing data relating to the Power of Attorney in a universally accessible electronic data base. This allows taxpayers to file their power of attorney forms at any service center handling their tax matter and allows instant access to the date by IRS employees regardless of their location. Taxpayers use Forms 8821 (Tax Information Authorization) or 2848 (Power of Attorney) to designate an appointee to receive and inspect confidential tax information or to represent them before the IRS. These forms may now be faxed to the Centralized Authorization File Unit at the service center where they normally send their tax returns. A list of service centers and fax numbers was included in the announcement. Go to our Power of Attorney page for a list of the numbers.
If you're thinking of filing false information returns (e.g., 1099s) to get someone in trouble with the IRS, don't. In David N. Bowman (99-1 USTC 50,510; U.S. Court of Appeals, 6th Circuit), the Court affirmed a lower court ruling assessing criminal penalties against the defendant.
If someone forgives a debt you owe them, the amount forgiven is generally cancellation of indebtedness income. The whole debt doesn't have to be forgiven; even a partial forgiveness will generate income. There are exceptions to the general rule. The forgiveness can be a gift (e.g., loans between relatives), the debtor can be insolvent, etc. In Martin M. Burke (99-1 USTC 50,512; U.S. Court of Appeals) a couple owed money to their wholly owned corporation. The corporation canceled the debt when the couple transferred property to the corporation. However, the value of the property was less than the debt owed. The taxpayers engaged in a number of other related transactions involving stock of the corporation. The Court of Appeals upheld a Tax Court decision, finding that the transactions had to be examined separately. Thus, the exchange of the lower-valued property for the debt produced cancellation of indebtedness income.
The IRS has issued proposed regulations on reporting payments to attorneys. All payments to attorneys made by a trade or business must be reported on a 1099-MISC, even if a portion of the payments go to the attorney's client. There is no threshold for reporting and the requirement applies to attorneys who do business as corporations.
You have 3 years from the date you filed your return to file an amended return to claim a refund. If you filed no return you have 2 years from the date you paid the tax to claim a refund. In the case of J. Leslie James (T.C. Memo. 1999-160) the taxpayer claimed he filed a return, but could not prove it. Even testimony and notes from the taxpayer's return preparer did not sway the Court. However, the Court did note that the taxpayer had a history of filing late. If you are filing on time, send it certified, or, better still, registered.
If your company maintains a qualified pension, profit- sharing, or other type of plan, you want to make sure you don't do anything to jeopardize the plan's status. In Roblene, Inc. (T.C. Memo. 1999-161) the sole shareholder was both an employee and an independent contractor for the business (he was an independent contractor with respect to sales commissions he received). The IRS argued that amounts contributed to the pension plan were excessive since they were based on both his salary and his compensation as an independent contractor. That destroyed the tax exempt status of the plan.
When at first we do deceive . . . in Lucio Ambroselli (T.C. Memo. 1999-158) the taxpayer was found guilty of fraud for failing to report the receipt of an illicit insurance recovery. The fact that he did not appear to prosecute his case was one of the factors that indicated he intended to conceal the income. Lying to the IRS about the income was another. The Court also noted that insurance proceeds were obtained by defrauding the insurance company.
If your expenditures or bank deposits would indicate that you underreported your income, you may be able to disprove the Service's reconstruction if you can show that you had other sources of cash that were not taxable, for example, a cash hoard from an earlier period. That's what the taxpayer in Paul Mifsud and Maria G. Mifsud claimed. The Court was unconvinced. It found their testimony unbelievable. Since the IRS was able to show fraud, the statute of limitations did not bar assessments for years that would have been barred.
At least one IRS district (Brooklyn) has announced that tax preparers can obtain special identification numbers to use in place of their social security numbers in tax returns they prepare. A new form, W-7P, will be available in time for preparers to get numbers for the filing season beginning January 1, 2000.
This is one Tax Court case that leveled the playing field for the taxpayer. Some background. If you think the IRS will challenge your activity as a hobby loss, you can file an election to postpone a challenge from the IRS until the close of the 4th year (6th year for horse breeding, showing, etc.). (Use Form 5213.) In Robert E. Wadlow and Connie V. Wadlow (112 TC--, No. 18) the taxpayer did just that. The IRS adjusted their returns for some of the years, but also filed a refund claim for certain years. The IRS said they were too late. The taxpayers argued that the statute of limitations for filing a claim was extended because filing Form 5213 was similar to an agreement to extend the period of assessment. The IRS said since the Service did not sign the form (only the taxpayer has to sign) the taxpayers were bound, but not the government. The Tax Court sided with the taxpayers. The election extended the statute for both the IRS and the taxpayer.
The IRS has announced the interest rates on under- and overpayments for the third quarter of 1999. The rates are unchanged from the second quarter. See our Interest Rate Tables for the new rates.
The Service has issued final regulations that revise the uniform premium table used to calculate the cost of employer- provided group-term life insurance coverage. Generally, the first $50,000 of term insurance purchased for employees is not considered income. Additional amounts must be included on the employee's W-2.
In the case of Larry J. Culley (99-1 USTC 50,492; U.S. Court of Federal Claims) the taxpayer sold the assets of his corporation to another corporation, reporting the gain on his tax return. Later it was discovered the taxpayer and his corporation had defrauded a customer through a bribery and kickback scheme. The customer sued and won a $1.2 million settlement. The buyer of the business sued the taxpayer, settling for $1.8 million. The taxpayer sought re-computation of his earlier tax return with regard to amounts previously reported as income from the former business. The Court found that the proceeds of the asset sale was income to the corporation not him. Thus, he couldn't claim a deduction for any repayments he made.
You can't pass off the responsibility for the payment of payroll taxes to another party to escape penalties for nonpayment. In Atlas Therapy, Inc. (99-1 USTC 50,497; U.S. District Court, No. Dist. Ala., So. Div.) the company had about 80 employees. It had run into employment tax problems earlier but had settled with the IRS. The company hired a chief financial officer. The president instructed him to contract with an independent third party to handle the payroll. The company's outside accountants were instructed to monitor the new financial officer's performance. The CFO did not deposit the payroll taxes and covered up his failure on the books of the company. The company fired him and hired a replacement, a CPA. The company informed the IRS and asked that any penalties be abated. The company argued that it did everything in it's power to insure payment of the taxes, thus it could show 'reasonable cause' for its failure. The Court sided with the IRS. The company and its president always retained the authority to oversee the CFO. It couldn't pass the responsibility on to its CFO. Keep this case in mind. Make sure you check that the taxes are deposited. Better yet, use a payroll service.
In a technical advice memorandum (TAM 199921046) the IRS ruled on what expenses a nursery must capitalize. The IRS made a distinction between the cost of plants that are purchased for immediate resale and those that are purchased for further development and cultivation before sale. The IRS concluded that the plants purchased for cultivation did not have to be capitalized, but could be expensed immediately, under the rules applicable to farmers. However, plants purchased for immediate resale had to be capitalized.
We've discussed hobby losses on more than one occasion. If the IRS claims an activity is really a hobby, your deductions will be limited to your income from the activity. While the courts look at a number of factors, the length of time the losses continue is an important consideration. In Rodney Taras, Linda Taras (99-1 USTC 50,489; U.S. Court of Appeals, 3rd Circuit) the Appeals Court upheld a Tax Court decision, finding that the taxpayer's horse racing, breeding and showing was a hobby. The Court particularly cited the fact that the taxpayers incurred losses over a 16-year period.
Think you can get the better of the IRS by holding on to your money till the very last minute? In Franklin K. Gregory (99-1 USTC 50,491; U.S. Court of Appeals, 6th Circuit) the taxpayer wrote the IRS two checks for $725,000 with his extension request on April 15. His accountants advised him it would take about 14 days for the checks to clear his accounts. Several days after mailing the checks he advised his broker to liquidate enough securities to cover one of the checks. The broker did not follow through until after his check was presented for payment by the IRS. For whatever reason, he did not try to cover the other check. The IRS charged the taxpayer dishonored check penalties of $14,500 and a late payment penalty for $14,556. The Court noted that a bad check penalty can be avoided if a taxpayer tenders a check 'in good faith and with reasonable cause to believe that it would be duly paid'. The Court found the taxpayer introduced no evidence to support that position. Documents created after he wrote the check were of no help.
If you don't have documentation for expenses, you may be able to rely on the mercy of the court. Under the Cohan rule the court may allow some or all of your expenses under the premise that you must have incurred at least some expenses. How well you fare depends importantly on the judge, your attempts at recordkeeping, and how convincing you are in your testimony. In Edward M. Fontanilla (T.C. Memo. 1999-156) the Court estimated the taxpayer's deductible expenses for work shoes and uniforms, cost of goods sold, and charitable contributions. The Court disallowed all the taxpayer's travel and auto expenses. Note. The Cohan rule can't be used for travel and entertainment expenses. The taxpayer was also subject to the negligence penalty.
The IRS has issued proposed regulations for accounting for income from long-term contracts. The regulations describe the use of the percentage of completion method, what activities fall under a de minimis rule, when non-long-term contract activities (e.g., engineering and designing) must be allocated to a long-term contract, when an agreement may be severed into two or more contracts, and the simplified cost-to-cost method.
Out-Of-Pocket Expenses May Not Be Deductible
Most business owners assume that if the expense meets the definition of "ordinary and necessary" and it's not prohibited by a section of the law, it should be deductible. Well, usually, but not always.
A case not too long ago (Hughes and Luce, LLP, T.C. Memo. 1994-559) and a letter ruling (9432002) both involved the deduction of reimbursable expenses by attorneys. The letter ruling involved an individual attorney; the case a partnership. Both taxpayers used the cash method of accounting. The facts were similar. In both cases the taxpayers incurred out-of-pocket costs for travel and meals, court costs, filing fees, expert fees and costs, corporate service charges, third-party photocopy services, long-distance telephone charges, delivery services, etc. The attorneys may or may not enter into written client agreements providing that the clients must reimburse the firm for the costs incurred. The firm pays these outside parties with one of its own checks. These costs are billed separately to the clients. Even with a written agreement the firm has no guarantee the costs will be paid by the client.
In addition to these costs the firm incurs in-house expenses related to the cases such as for secretarial services, on-line legal research, photocopying, etc. Clients are billed for in- house services based in part on the firm's cost, but also on what similar firms are charging in the area.
In some situations the firm may decide not to bill the client for its out-of-pocket expenses. There can be a number of valid reasons such as:
The second situation involves out-of-pocket expenses (amounts for outside services) for which the taxpayer expects to be reimbursed by the client. These are not deductible expenses. Instead, when a taxpayer makes expenditures under an agreement that he will be reimbursed, the expenditures are in the nature of a loan or advance to another and are not deductible as business expenses. In the same way, when reimbursed for the expense, the taxpayer has no income. If reimbursement is not made, any amount not reimbursed can be deducted as a bad debt.
Example--In 1999 Fred Flood incurs $1,000 in out-of-pocket charges for client Madison Inc. and $2,500 in similar charges for Chatham Co. At the end of 1999, neither client has paid Fred. Fred cannot deduct either of the charges. In 2000 Madison reimburses Fred the full $1,000. Fred reports no income. Later in 2000 it's clear Chatham will never be financially able to reimburse Fred. Fred can take a bad debt deduction for the $2,500.
The third situation involves out-of-pocket expenses that will never be billed to the client. For example, where the amounts are small or for some other business reason the taxpayer decides not to bill the client. In such cases the expenditures are deductible when incurred.
In an earlier case (Jostens, Inc., T.C.M. 19989-656) the taxpayer manufactured school class rings and often did not attempt to collect finance charges on customer's past due accounts. The taxpayer relied on repeat business and believed it would not be good business practice to press for the charges. The taxpayer sought a bad debt deduction for the canceled finance charges. The Court did not question the taxpayer's business judgment, but denied the deduction because the taxpayer failed to demonstrate that the canceled debts were worthless.
The cases and letter ruling discussed above aren't new law. The issue has come up in the past with similar results. Whether or not an expense is deductible will depend on the facts and circumstances. If you anticipate reimbursement from your client, your payment of expenses may be just a loan to the client. That's not the best position to be in. Should the client not pay, you must be able to show the debt is worthless in order to secure a bad debt deduction. That can often be difficult. You may be able to escape the trap by having a policy of not seeking reimbursement. In that case your agreement with the client should be a lump-sum contract, not indicated an expense reimbursement. Facts and circumstances are important here. Check with your tax adviser to see how the rules affect you.
Finally, the Josten's case emphasizes the point that, if you've billed a customer, you must make every effort to collect the amount. Even if you decide not to pursue collection for a valid business reason, you may lose a bad debt deduction.
In our last issue we discussed the deductibility of home mortgage interest. If you're buying or refinancing a home, taking out a home equity loan, or even taking out a business loan, you may have to pay 'points' when closing on the loan. Since points are paid up front, how you get to deduct them is very important. One point is equal to 1% of the principal amount of the loan. (E.g., 2 points on a $150,000 loan is $3,000.
Unfortunately, there's no universal definition of points. Some people use the term to include prepaid interest, bank charges and fees, etc. The IRS uses a narrow definition. Only a loan origination fee, loan discount, or discount points are considered points.
Finance tip--If you're comparing two loans with different terms, you've got to do your homework to figure out which one is best. We're not talking taxes here, just pure economics. The first step is to break out all the costs and put them in their respective categories. What you should be left with is any points charged for getting the loan or for prepaid interest. The points that represent interest should lower the interest rate on the loan. For example, a 25-year loan at 7.0% with 2 points is roughly equivalent to a 25-year loan at 7.22% with no points. You'll need a financial calculator and maybe professional help to make a true comparison. The equivalency depends on the interest rate, points and term of the loan. Things get trickier if you plan to or might pay off the loan early. If you pay the interest up front by way of points and then sell your home or pay off the loan early, you'll have lost the benefit of the lower interest rate in the later years. Best advice? If you think you're going to pay off the loan early, try to avoid paying points.
For tax purposes, the general rule is that you can't deduct the points up front. You must amortize them over the life of the loan. However, you can deduct points in the year you pay them if you meet all the following tests:
You can also fully deduct in the year paid points you paid on a loan to improve your main home. You must pass the first five tests listed above.
If the seller pays the points for you, you can treat them as if you paid them, but you must reduce your cost basis in the house. For example, you purchase a home for $190,000 and take out a $150,000 mortgage. The seller agrees to pay the points, $3,000. You can deduct the $3,000 on your return for the year you purchase the house, but you must reduce your cost basis by that amount. That means your cost basis would be $187,000. That would be your basis for computing a gain or loss on the sale (up to $500,000/$250,000 of gain is not reportable if you hold the house for at least 2 years), for computing depreciation on a home office, etc.
Test 9 above, needs a little explanation. Basically, if you contribute none of your own funds, you can't deduct the points. That's unlikely to occur. Most lenders will require you to put down at least 5%. However, if your down payment is very small, check with your tax advisor to be sure the points are deductible.
If you pay points that are more than those generally charged in your area (e.g., you pay 3 points and 2 points are customary), the excess points are not deductible. Instead, the extra point(s) are considered prepaid interest that you must spread over the life of the mortgage.
If the points aren't deductible up front, you can generally amortize them over the life of the loan. This rule applies to a refinancing, a home equity loan, a second home, or any situation where you can't deduct the points up front. You can also amortize points on a business loan. If you have to amortize the points, you can generally deduct any unamortized amount in the year the mortgage ends due to a prepayment, refinancing, foreclosure, etc.
Example--Fred and Sue Flood refinance an existing mortgage. They pay $3,000 in points on a 20-year loan. They close on the refinancing on August 1, 1999. They've got to spread the points over 20 years, or 240 months. That's $12.50 per month. For 1999 Fred and Sue can deduct $62.50 (5 x $12.50). For each year beginning with 2000 (except the last year) they can deduct $150.
What if the loan proceeds are used for more than one purpose? For example, you have an existing loan on your home for $100,000. Your equity is much higher than when you bought the house, so you take out a loan for $150,000, using the extra $50,000 to improve the house. You pay $3,000 in points. You can deduct the points that apply to the portion of the loan used for your home improvement project. Thus, $1,000 of the points ($50,000/$150,000 X $3,000) would be deductible. The remainder ($2,000) would be amortizable over the term of the refinancing. You would have to do a similar allocation if you borrowed money for a home improvement, but used a portion of the proceeds for other purposes.
A final note. Be sure to deduct the points, either the full amount or the annual amortization, in the right place. If the loan is personal, use Schedule A of Form 1040. Points that were reported on a 1098 are entered in one spot; those not reported on a Form 1098 are reported on another line. If you're amortizing points, loan origination fees, etc. on a business loan, for the first year you must enter the amount in Part VI of Form 4562.
Sometimes innocent mistakes can have disastrous tax consequences. Here's a situation where trying to fudge a little cost the taxpayers big money.
If you rent property to strangers you don't really have to worry about what you charge them for rent. The issue of a fair rental amount rarely comes into play. It's generally assumed that if the other party in a transaction isn't a relative, the amounts were agreed on as a result of good faith bargaining, or there is no other motive involved (such as a side business deal) the transaction will be at arm's length. The rent may be too low, but the IRS can't penalize you for charging too little.
But if you rent to relatives, the rules change completely, especially when it comes to residential property. Code Sec. 280A provides that, when an individual uses a dwelling unit for personal purposes for any day during the taxable year, the amount deductible with respect to expenses attributable to the rental of the dwelling unit is limited for the days that the unit is used for personal purposes. The expenses are generally limited to the amount of the rental income.
In Vashon C. Jackson (T.C. Memo. 1999-226) the taxpayers purchased a house owned by the wife's parents. The parents continued to live in the house and the taxpayers charged the parents rent of $500 per month. They claimed expenses associated with the property of about $24,000 a year for each of 3 years at issue.
The taxpayers started off on the right foot. They contacted a real estate agent to determine a fair rental amount for the property. The agency indicated a fair rental would be $600 per month. Apparently, the taxpayers charged their parents only $500. That's what the taxpayer testified to at trail. He also testified that he reported $600 per month, but the taxpayers could only show income of $500. And that's where things started going bad.
Since the property was rented for less than a fair rental amount and the property was used by relatives, it was considered used for personal purposes for every day that it was rented for less than a fair rental amount. That meant it was used for personal purposes for every day of the year. That also meant their deductions were limited. How limited? In this case the only deductions they were allowed were those for mortgage interest and real estate taxes. And, since they could have claimed the house as a second home, those amounts would have been deductible even if they hadn't reported any income from the property.
Thus, because they charged their parents $1,200 a year less than a fair rental, they lost over $7,000 a year in deductions. (The IRS found that of the $24,000 or so in expenses, the taxpayers could only substantiate about $12,000 a year.)
Since the Court didn't have to go any further after it found the $500 monthly rental was below the $600 fair rental value indicated by the real estate agent, there were some points left unanswered. First, the taxpayer received the appraisal of the fair market rent in 1988. It was still 'charging' the same amount in 1991, 1992, and 1993. The fair rental value changes with time and circumstances. It could go down, but it's more likely to go up. Get a fresh appraisal at least every two years. You might be able to avoid that if you have a long lease (3 to 5 years) and put escalation clauses in the lease. For example, a 3% increase every year. Second, the taxpayer got only one appraisal. There's too much at risk here not to get a second appraisal. Get two and take the average. Better yet, use the higher one. If you're determined to get just one, add a safety factor and charge a slightly higher rent. Third, the taxpayers claimed expenses of $24,000 and income of $7,200 per year. That's a huge discrepancy. While most rental properties generate losses during the first few years, the expenses shouldn't be several times the income. That should be a tip-off to you something is wrong. Worse, it's a tip-off to the IRS. An agent doesn't have to do much more than glance at Schedule E to become suspicious.
You think you're doing business as a corporation or sole proprietorship and during an audit the agent says you haven't filed partnership returns for the past 6 years. Not only do you have to file returns and pay penalties, you've also got to amend your personal and business tax returns. Unlikely? Not really. Here are two situations where taxpayers were faced with just this situation.
The first situation involved a technical advice memorandum (TAM 199922014). The taxpayer, we'll call it Madison Health Inc., was a service organization (e.g., a health care provider) that entered into a service agreement with a publicly traded company we'll call Chatham Inc. In return for service fees, Chatham provides Madison with offices and facilities, equipment, supplies, support personnel, and management and financial advisory services. Chatham is also responsible for all costs of repairs, maintenance and improvements, utility expenses, normal janitorial services, refuse disposal and all other costs and expenses reasonable incurred in conducting operations in the office. Chatham is specifically reimbursed for such costs. In addition to reimbursing Chatham for these expenses, Madison pays a service fee, generally based on a percentage of Madison's net income. As part of the agreement, Madison sold its assets and properties, tangible and intangible (e.g., accounts receivable) used in the business. Only assets that are necessary to the performance of its administrative and office management services were transferred.
Although Chatham provides administrative and support services, consistent with state and federal laws, Chatham is prohibited by law from participating in the core component of Madison's business. Madison retains the sole authority to direct the business, professional, and ethical aspects of its business practice. Matters involving the internal agreements and finances of Madison including the distribution of professional service income among the individual professionals, remains the responsibility of Madison. Under the agreement, Chatham acquires Madison's outstanding accounts receivable. If Chatham collects more than the amount paid for the receivables, or if it cannot collect the entire amount, Chatham accounts for the differences and adjusts the acquisition price of the next month's receivables.
The service agreement expressly states that Chatham and Madison intend that Chatham will perform its services as an independent contractor and not as a partner. While the service agreement states the intent of the parties not to form a partnership, Chatham's promotional literature refers to the parties as partners. Neither Madison nor Chatham hold themselves out to third parties as a partner in a partnership. After an agreement is signed, there is no change in the name of the service business (i.e., Madison). Even though Chatham's employees interact with Madison's clients in the office, clients are not told these individuals are Chatham's employees. Chatham's name does not appear on any correspondence. Both parties maintain separate books and records, but a Chatham employee maintains Madison's books.
Whether a partnership exists depends on the facts and circumstances. The mere sharing of expenses (such as two farmers agreeing to pay half the cost of constructing and maintaining a drainage ditch), does not create a partnership. However, the sharing of profits usually does indicate a partnership. Here, the IRS found that no partnership existed. The surprising thing was that an agent asked and the IRS did not dismiss the possibility of a partnership out of hand. If it had not been for the language in the contract specifically stating that it was not the intent of the parties to create a partnership, the outcome might have been different.
In the second situation, (field service advice (FSA 1999- 1226)) the result was not as favorable to the taxpayer. Here a corporation constructed a luxury resort hotel complex containing apartments and the typical amenities accompanying such resorts. Individuals bought condominium units. Each purchaser was required to enter into a agency management agreement with the promoter for the rental of his or her unit to guests when the owners were not using the unit.
Generally, when condo owners agree to a rental arrangement the owner's unit is either rented under a agreement where the management company acts as an agent for individual units in the building or the units are pooled, but the manager keeps track of the rent for each unit. For example, if you own a unit you receive income for each day your unit is rented. Your unit may get rented more or less frequently than other units and that will determine your income. However, in this situation, the rental pool arrangement allocated income based on the aggregate days of unit availability, whether rented or not. Thus, assuming your unit was available 365 days a year, you could earn income for all those days, even if the unit was never occupied.
The IRS found that the deal was characteristic of a business arrangement, not a simple intent to share costs. The next step was to determine the type of arrangement. Whether the arrangement is a corporation or a partnership depends on whether the entity has centralized management, continuity of life, free transferability of ownership and limited liability. The IRS found that the entity had the characteristics of a partnership.
The IRS held that the arrangement was really a partnership. How much of an impact that would make on the individual partner's returns depends on the facts. Since the condo owners already reported their share of the income on their returns, the impact could be small.
The first situation involved a technical advice memorandum, the second, field service advice. Neither can be cited as precedent. However, such documents generally show the intent of the IRS. There have been other situations recently. That could mean the IRS is starting to attack such arrangements. Vending machines in a retail store have been held to create a partnership between the store owner and machine owner. The payment of percentage rent for a store lease could be construed as creating a partnership. Any agreement that calls for profit sharing should be discussed with your tax advisor.
There are ways to avoid the problem. One is to make sure the agreement clearly states that a partnership is not intended. Another is to try and structure the relationship like one between an independent contractor and the company that engages his services. There should be no mutual control; one party should be dominant. Talk to your tax adviser for specific ideas in your situation.
Home Office Deduction--How Much is it Worth?
In our December 1, 1998 issue we reported on the new rules for home office deductions. Starting in 1999 it's much easier to qualify. We've had a number of questions on just how much the deduction is worth. We spent some time working through some assumptions. While the numbers will give you a better idea, there are still variables that are tough to quantify. If you haven't done so, read our December 1, 1998 issue first.
There are some many variables involved it the computation of a home office deduction. We tried to arrive at assumptions that would be typical of what you might encounter. For example, we assumed utilities (electric, fuel oil, etc., but not telephone) on our first home would be $2,000 annually. That would be low if you live in northern Minnesota, but could be high in some other areas of the country. We figured repairs at $1,500; again, that could be low or high. But you'll get an idea of the relative size of the final deduction, and that's what's important. Another point. We omitted the deduction for interest and real estate taxes. A portion of these expenses would be deductible as a home office expense. But, if you itemize, you'd be able to deduct these anyway, so for simplicity we left them out. (There are some fine points; see below).
Before reviewing the examples, we should discuss some tax theory about the basis in your house. Your basis is important since that's the starting point for computing depreciation. Your basis is generally your cost. It's what you paid in cash and any loans you took out. If you're converting all or a portion of the home to business use sometime after purchase, your basis is the lesser of your cost or the fair market value at the time of conversion. And, for depreciation purposes, your basis doesn't include the cost of the land.
Example--Fred bought his home several years ago for $100,000. In 1999 he set up a home office. The house is now worth $150,000. His basis is only $100,000. When he purchased the house part of the purchase price was for the land. How much? While there are several ways of arriving at the value of the house without the land (you could have an appraisal), the easiest one (and one that's generally accepted by the IRS), is to use the allocation on the real estate tax bill. In Fred's case, the bill showed that 15% was allocated to the land. Thus, for depreciation purposes, Fred can use $85,000 as his basis in the house.
In the example above we assumed that this was Fred's first home. What if it wasn't and he rolled over the gain on a prior home? His basis in the new house would be his basis in the old plus any additional cash or loans he invested to purchase the new house.
Example--Fred bought his first home in 1985 for $100,000. He sold the house in 1996 for $350,000, rolled over the gain, and purchased a new one for $400,000. His basis in the new home is $150,000--the cost of the first home plus the additional $50,000 he paid for the new home.
Now to the examples.
Home 1--
Purchase price (less value of land) $ 30,000 Insurance 700 Repairs and maintenance 1,500 Utilities 2,000 Total area of home 1,500 sq.ft. Area used for business 150 sq.ft. Percentage used for business 10% Deduction for home office $ 497 Tax saving at 28% 139While the purchase price here appears to be low, it's not unusual. You may have purchased the home in the 70's.
Home 2--
Purchase price (less value of land) $300,000 Insurance 1,500 Repairs and maintenance 3,000 Utilities 3,500 Total area of home 2,500 sq.ft. Area used for business 350 sq.ft. Percentage used for business 14% Deduction for home office $ 2,197 Tax saving at 28% 615
Home 3--
Purchase price (less value of land) $300,000 Insurance 1,500 Repairs and maintenance 3,000 Utilities 3,500 Total area of home 2,500 sq.ft. Area used for business 500 sq.ft. Percentage used for business 20% Deduction for home office $ 3,183 Tax saving at 28% 878Notice in this example 20% of the house is used for business. That's a high percentage, but not improbable for some small business owners. What would the tax saving be if the owner were in the 36% bracket? About $1,130.
Home 4--
Purchase price (less value of land) $300,000 Insurance 1,500 Repairs and maintenance 3,000 Utilities 3,500 Total area of home 2,500 sq.ft. Area used for business 350 sq.ft. Percentage used for business 14% Deduction for home office $ 1,228 Tax saving at 28% 344The assumption here is that the taxpayer rolled over the gain in his old house and bought a much more expensive one (say $300,000). Insurance, repairs, etc. are all higher, but his basis for depreciation purposes is still the $30,000 he paid for his original home.
You can see by the numbers that the tax savings aren't that impressive until you have a more expensive home to depreciate, use a higher percentage for business, etc. At the low end, the savings are minimal. But what about the other variables we hinted at above? Here are some other points to consider.
Self-employment tax. If you're paying the full self- employment tax (you're not above $72,600 (1999 amount)) there's an extra saving of about 12%. Thus, in Home 3, that would add about $376 in tax saving, bringing the total to $1,254.
Itemized deductions. If you're income is high enough that you begin to lose some of your itemized deductions, or you can't itemize because your other deductions aren't high enough, shifting at least a part of your mortgage interest and real estate taxes to a home office deduction could save a few more dollars. The fact that a portion of your interest and real estate taxes would reduce your self-employment tax would provide additional savings.
Sale of house. The portion of the house used for business is not part of your principal residence. That means if you sell the house, that amount of the gain times your business usage can't be excluded. For example, your total gain is $100,000 and your business usage is 15%. You've got to pay capital gains tax on $15,000. At 20% that would be $3,000. It could offset several years of tax savings. You can avoid this problem if you don't claim the home office deduction for at least 2 years before the sale.
Does it make sense? Check the examples above. If you're closer to Homes 2 or 3, you should certainly consider claiming the deduction. If you're closer to Home 1, it may not make sense.
Current Yield vs. Yield To Maturity
There are two basic measures of a return on bonds (and other fixed income investments). Once is current yield; that's simply the stated yield or the annual coupon payment divided by the price of the bond. A bond purchased for $1,000 that pays $80 per year has a current yield of 8%.
The second measure is the yield to maturity. This yardstick takes into account the fact that you might pay more (a premium) or less (a discount) than the face value for the bond. Finding the yield to maturity requires discounting that premium or discount. The computations are easier today, but you'll need a financial calculator or spreadsheet program. The yield to maturity is the same as the current yield only if the purchase price is equal to the amount you'll receive at maturity. And that's rarely the case.
Example--A bond with 10 years to maturity and an 11% coupon ($110 of interest annually) may be purchased for $1,150. The current yield is 9.56% ($110 divided by $1,150). But the yield to maturity is only 8.69%. That's because at maturity you'll only receive $1,000. In effect, the $150 premium you pay for the bond reflects the higher current yield. Even if market interest rates remain the same, as the bond approaches maturity a buyer would pay you less each year since at maturity he will never get more than $1,000. The tax laws recognize this and generally allow you to take an annual deduction (amortize) any bond premiums.
The only major risk with buying bonds at a premium is that some bonds are callable. If the bond is called you may lose part or all of the premium you paid. Otherwise, two bonds with the same yield to maturity are equal (assuming the same quality, term, tax factors, etc.).
Things are different if you're looking at a bond fund. You may only see the current yield. If the fund has substantial holdings of bonds purchased at a premium, the yield over a period of time may look attractive, but the net asset value (NAV) of the fund may be declining because the premium a buyer will pay for those bonds declines every year. There's a tradeoff between current yield and capital. Thus, unless you consider both the current yield and the change in NAV, you're not properly analyzing the fund.
Things can get worse if you add taxes to the analysis. You're paying taxes on the high current yield, but get no benefit for the drop in NAV until you sell the fund, and that could be some years down the road. Taxes aren't a consideration if the fund is in a qualified retirement plan (e.g., an IRA, 401(k), etc.). Remember, if you owned the bonds outright, the bond premium could be amortized each year.
The discussion above assumes that the bonds are taxable. Some of the information is the same for tax-exempt issues, but the tax consequences are different.
If you're investing in individual bonds, compare yields to maturity. And get complete information on the bond. Is it callable? When? Are there special provisions that can affect the value? If you're looking at a bond fund, check the prospectus carefully.
Previously Reported In Daily Update
Negotiating strategy . . . Don't give in too early. Fight for all your points. By doing so you'll build up a reserve of items. Then when the time comes for you to give up something in order to gain points or save the deal, you'll be able to trade items you didn't really want that bad in the beginning. You'll also make your adversary feel that he's won points from you. But know when to give in. Don't fight so hard that you kill the deal.
Mail bills faster . . . There's no need to wait to send a bill to a customer. Send it as soon as the product ships. The quicker you send the bill the quicker you'll get paid. If you sometimes have very large invoices, consider mailing them using a priority service such as FedEx. For example, customer orders typically fall between $100 and $1,000. However, several times a month you sell in bulk. These orders can be as much as $60,000. Consider using a faster method where you get delivery confirmation.
Buyout package . . . When attempting to downsize a business you might offer buyouts to some employees. Get good counsel before you do. You may find too many people, or the wrong people, accepting the offer. In short, you may lose some people you want to keep. You may still have to pay unemployment for those people who accept the buyout. Finally, be careful you don't run afoul of any antidiscrimination laws, particularly those involving age discrimination.
Casualty loss deduction . . . Chances are good that your casualty loss may be covered by insurance. But what if you incur the loss in one year and the insurance company doesn't reimburse you in that year, but does so in the following year? For example, you sustain a casualty loss in 1999. The insurance company stalls your claim and, by the time you go to file your 1999 return you haven't received any payment. However, in late 2000 the company pays you in full. How do you handle this situation for tax purposes? It depends on the circumstances. If you had a reasonable prospect of recovery from the company in 1999, even though payment isn't made until a later year, you can't take a casualty loss in 1999. If, however, there was a reasonable doubt that the company wouldn't pay, you can take the loss in 1999 and include the reimbursement in income in the year received.
LLCs and employment taxes . . . If a corporation fails to pay employment taxes, the only taxes for which an employee, shareholder, or other person can be held personally responsible are those withheld from the employees. Other taxes, such as the employer's portion of FICA, don't carry personal responsibility. But the results may be different for a single member LLC. For federal tax purposes such an LLC that doesn't elect to be taxed as a corporation may not have the same immunity. That's what the IRS held in a recent legal memorandum (ILM 199922053). The theory is, since for other tax purposes the entity is disregarded, the same rules should also apply for liability purposes. (E.g., the income and expenses of a single member LLC is reported on the owner's Schedule C of Form 1040.) If you pay your taxes on time, this ruling shouldn't be of immediate concern. If you're worried, check with your attorney or tax advisor.
Part-time employees . . . For income tax withholding and social security, Medicare, and federal unemployment (FUTA) tax purposes, there are no differences between full-time employees, part-time employees, and employees hired for short periods. It does not matter whether the worker has another job or has the maximum amount of social security tax withheld by another employer. Income tax withholding may be figured the same way as for full-time workers. There's another option here. For part- time workers you can compute income tax withholdings using the part-year employment method. See IRS Publication 15-A.
Lease tickler . . . If you lease real estate, equipment, etc. chances are there are option clauses. In the case of real estate it may be an option to renew. For equipment it might be a buyout option at lease end. Make sure you've got the date on a calendar (electronic or old style) so that you don't forget. Failure to provide notice on time (often 30 or 60 days before lease expiration) can result in the loss of a significant benefit. Worse, in some cases the option is written in a negative format. That is, failure to inform the lessor will result in an automatic renewal.
Check due dates . . . Most loan agreements, mortgages, credit cards, etc. used to specify that payments were on time if they were postmarked by the due date. That may not be true any more. A number of banks and other lenders have changed the rules. In order to be on time the payments must be received by the due date. To make it worse, many companies have upped late payment fees. Check your agreement and allow extra time.
Deducting boats and condos . . . The expense of operating a boat, hunting lodge, or similar entertainment facility are expressly nondeductible. However, one taxpayer got around the problem, at least in part. The company allowed employees to use a boat and condo owned by the company. However, the company reported the use as additional income on the employees' W-2s. The Service concluded that the company could deduct the portion of the expenses treated as compensation. Check with your tax advisor before contemplating such a move. Refer him to FSA 1999- 1106. (Note. While field service advice issued by the IRS has no precedential value, it's a good indication of IRS thinking on an issue.)
Advance payments subject to sales tax? . . . Check the rules in your state. Advance payments on a taxable service contract or as progress payments on specially built equipment may not be subject to sales tax until the actual work is accomplished or the equipment delivered.
NOL use disallowed . . . You've some NOLs (net operating loss carryforwards). There's a business you can purchase for a bargain, less than the fair market value of the assets. You buy the business and sell the assets for a profit. You pay no taxes on the profit because you use the NOL to offset the gain on the asset sales. That's what a taxpayer did in some recently issued field service advice. But the IRS did not go along. It disallowed the offset, citing section 269 which prevents tax avoidance through corporate acquisitions to obtain the benefits of a deduction, credit, or other allowance. Be careful when making any acquisitions with a tax purpose as the principal intent. While it may work, there's an even better chance it won't. Check with your tax advisor before committing. (Note. While field service advice issued by the IRS has no precedential value, it's a good indication of IRS thinking on an issue.)
Charitable contributions . . . You've probably heard the ads. Donate your vehicle, no matter how run down, and get a tax deduction for your charitable contribution. The IRS is aware that some programs are promising contributors a deduction at full blue book value. Some are even giving donors gifts in return for the donation. Be aware that the IRS and state attorneys general are looking into such programs. Legitimate ones have nothing to worry about. There are some serious consequences for those that aren't. You should keep in mind that you can only deduct the fair market value of the vehicle. That may be the blue book amount, but only if the car is running. And keep in mind that you've got to adjust for condition. Moreover, if you receive something in return, you've got to reduce your contribution by the fair market value of that item. For example, you contribute a car worth $1,200, but receive 50 rolls of film worth $150. Your deduction is limited to $1,050. If the charity's deal sounds too good to be true, it probably is. Best to steer clear. If the charity is audited, the IRS will get your name. It's not worth it.
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