News On The Tax Front--The latest tax news.
In Brief:--Tax, business, and personal finance tips.
Previously Reported In Daily Update
Check for liens before buying or lending money on any property. In In re Karl Robert Simms, Debtor (2003-2 USTC 50,570; U.S. Bankruptcy Court, So. Dist. W.V.) a mortgage company claimed it was entitled to the proceeds of sale of mortgaged real estate because it satisfied the previous mortgage of the debtor. The Court held the lender negligently extended financing under circumstances that prevented it from obtaining adequate security. The Court noted a simple title search prior to the extension of financing would have disclosed the existence of liens that far exceeded the value of the property. The Court held not only did the IRS have prior liens, but the fact that the lender did not have priority was due to its own carelessness. Thus, the doctrine of equitable subrogation did not apply.
Members of a consolidated group of corporations generally cannot take losses on intercompany transactions (transactions between entities). Only when the transaction passed outside the group can the losses be deducted for tax purposes. For example, if Subsidiary A sells property for less than its cost basis to Parent P, the loss is not deductible. When Parent P sells the property to an unrelated party, the loss will be deductible. In Textron Inc. (2003-2 USTC 50,571; U.S. Court of Appeals, 1st Circuit) the Court reversed the Tax Court (115 TC 104) with respect to a capital loss on the redemption of a promissory note made by a subsidiary. The Tax Court disallowed the loss. The Appeals Court held the taxpayer could take the loss. Although the subsidiary was a member of the group at the time of redemption, it was not a member at the time the note was executed. The Court allowed the capital loss.
Who gets the dependency exemption if divorced parents have split custody? That was the issue in Marvina J. Dail (T.C. Memo. 2003-211). The Court held the wife was entitled to the dependency exemption and head of household status because she had physical custody of the chile for the larger portion of the year and her home was the principal place of abode for her son.
If you own stock in an S corporation you can deduct a proportionate share of the corporation's loss to the extent the loss does not exceed the sum of your adjusted basis in the stock and any indebtedness of the S corporation to you. In Diane S. Blodgett (T.C. Memo. 2003-212) the Court held the taxpayer was not entitled to deduct a business carryover loss. The taxpayer failed to present any evidence to establish her basis in the stock of the S corporation. Further, there was no evidence that the business was indebted to her. Without basis in her stock or qualifying debt with respect to her ownership in the corporation, the taxpayer could not deduct any portion of a net operating loss of that corporation. In another issue, the Court held the taxpayer was not entitled to a theft loss of a pension plan based on allegations of fraud, theft, estoppel, and breach of fiduciary duty by the bankruptcy trustee and Internal Revenue Service officials. No evidence was presented to show what, if any, actions were taken by her in the bankruptcy court to rectify these claims. In order to sustain a theft loss deduction, a taxpayer has the burden of proving a loss discovered in the taxable year was incurred as a result of a casualty or theft and the amount of such loss.
There aren't too many acceptable excuses for failing to file. Mental illness or mental incapacity can constitute reasonable cause. However, if the taxpayer is able to exercise ordinary care and prudence with respect to nontax matters, the claimed mental illness or mental incapacity does not constitute reasonable cause. In Edward Kazuo Ozaki (T.C. Memo. 2003-213) the taxpayer claimed mental illness caused by failure of U.S. Government to acknowledge that violation of constitutional and civil rights of Japanese Americans during World War II has debilitating and demoralizing effects on the child (Edward Kazuo Ozaki) of U.S. concentration camp survivors. The Court held that, except for the taxpayer's testimony, he presented no evidence that he had a mental illness or mental incapacity which prevented him from filing a return for each of the years at issue. In fact, the record established that, throughout the years at issue until the time of the trial, the taxpayer worked as a sales manager and as a singer/composer and has almost doubled his income throughout that period.
If you don't keep adequate records, the IRS can reconstruct your income by any method that is reasonable under the circumstances. The reconstruction need not be exact, so long as it is reasonable and substantially correct. As a general rule, the taxpayer bears the burden of proving the Service's determinations to be in error. Certain courts have recognized a limited exception to the general rule where the notice of deficiency determines that the taxpayer failed to report income, particularly income derived from illegal activities. In such circumstances, the IRS must come forward with evidence establishing a minimal foundation, which may consist of evidence linking the taxpayer with an income-producing activity. In Eddie Lee Williams (T.C. Memo. 2003-216) the Court noted the IRS showed that taxpayer was convicted of the illegal distribution of cocaine, and that he received and spent proceeds from the sale thereof, the IRS has linked petitioner to the relevant income-producing activity. The IRS provided this Court with summary documents evidencing the various cash deposits and expenditures underlying his determination of the amounts of unreported income. The Court allowed the Service's reconstruction of income.
Proceeds received from a bona fide loan are not income. But the distinction can sometimes be blurry. In Erection Post Acquisition, Inc. (T.C. Memo. 2003-218) the taxpayer received $175,000 from a oil company to assist in improvements and other costs associated with a station the taxpayer was opening. The taxpayer argued the amount was a loan, evidenced by a formal loan agreement. Portions of the loan could be forgiven if the taxpayer remained in good standing with the oil company after a certain period of time. The IRS argued that, since the loan could be forgiven and was subordinated, the amounts represented advance payments and, thus, income. The Court sided with the taxpayer, noting the agreement was standard practice between the oil company and station owners. The Court noted that the oil company had a history of pressing for repayment and that the formalities of a true debt were observed. (It should be noted that the taxpayer might have encouraged the IRS action by labeling the proceeds as deferred income.)
Owning property personally and renting it to your business often makes sense. But you've got to do it correctly. In Curtis R. and Lynn Bitker (T.C. Memo. 2003-209) the taxpayers, as partners, allowed the partnership to use their farmland. The partnership made the interest and principal payments on the mortgage on the farmland and the partnership deducted the payments as rent. The Court did not agree. It found that the taxpayers offered no evidence, testimonial or otherwise, that (a) the Bitker partnership made the payments as rent for such use or (b) the payments represented fair rental value. Moreover, the record was silent as to the number of acres used by the Bitker partnership. The Court held the taxpayers failed to provide any information or substantiation that would permit it to estimate the allowable deductions and disallowed any deduction for rent. The taxpayers income would not be increased by the amount of the payments (since they were not rent but distributions), but the payments would reduce the taxpayers basis in the partnership. (The correct way to handle the situation would be to set up a rental agreement using a standard form and use a fair market rent in the agreement.) The Court agreed with the taxpayers that wives of the original partners did have basis in their partnership interest because they received them as gifts from their husbands. In addition, the Court found the Service's duty of consistency argument was not applicable.
The IRS has issued final regulations (T.D. 9082) under Sections 897, 1445, and 6109 that require foreign transferors of U.S. real property interests (and transferees where applicable) to provide their taxpayer identifying numbers (TINs) on withholding tax returns, applications for withholding certificates, and other notices and elections under sections 897 and 1445 and the regulations thereunder. TINs are required so that the IRS can identify foreign taxpayers and more easily match applications, withholding tax returns, notices, and elections with the transferors' income tax returns.
You'll need more than your own testimony to support a deduction. In Thomas Rice (T.C. Memo. 2003-208) the taxpayer claimed dependency exemptions for his two children. His wife who filed married, separate, also claimed the exemptions. The taxpayer had no evidence, other that his own testimony, that he provided over half the support for the children. The Court disallowed the exemptions.
The IRS has issued final regulations (T.D. 9083) relating to golden parachute payments under Section 280G. These regulations incorporate changes and clarifications to reflect comments received concerning the proposed regulations primarily concerning the small corporation exemption, prepayment of the excise tax, and the definition of change in ownership or control. In Rev. Proc. 2003-68 (IRB 2003-34) the IRS provided guidance on the valuation of stock options for purposes of Sections 280G and 4999.
The IRS has issued proposed regulations (REG-128203-02) relating to partnership transactions involving contracts accounted for under a long-term contract method of accounting. The regulations are necessary to resolve issues that were reserved in final regulations under Sec. 460 that were published May 15, 2002, addressing other mid-contract changes in taxpayer engaged in completing such contracts. The effect of the regulations is to explain the tax consequences of these partnership transactions.
You may be able to avoid the joint and several liability that may arise from a spouse or ex-spouse. But you'll have to meet certain criteria. In Cynthia Emery Weight (T.C. Memo. 2003-214) the Court denied innocent spouse relief to the taxpayer, finding she knew of the distribution of pension withdrawals which were deposited in her daughter's savings account. In addition, the joint return was prepared by the same person who prepared the taxpayer's separate return and the taxpayer's divorce attorney coordinated the filing of the joint return. The Court found the taxpayer either possessed actual knowledge that a portion of the liability reported on that joint return was not paid, or such knowledge is imputed to her.
You should always keep documentation of expenses for tax purposes. That's even more important if you're dealing with family members. In Christopher Y. Kimm (T.C. Memo. 2003-215) the IRS denied the taxpayer's business a deduction for consulting payments made to his father. The Court sided with the IRS noting that the taxpayer did not provide the Court with any documentation that work was actually done. However, the Court did not allow the accuracy related penalty, finding the taxpayer, in good faith, relied on his attorney/accountant in claiming the deduction.
The IRS has issued final regulations (T.D. 9084) contains final regulations under section 1503(d) regarding the events that require the recapture of dual consolidated losses. These regulations are issued to facilitate compliance by taxpayers with the dual consolidated loss provisions. The regulations generally provide that certain events will not trigger recapture of a dual consolidated loss or payment of the associated interest charge. The regulations provide for the filing of certain agreements in such cases. This document also makes clarifying and conforming changes to the current regulations.
After reviewing the comments submitted by practitioners and others, the IRS announced (IR-2003-97) it will launch the Earned Income Tax Credit (EITC) certification pilot program in early 2004 with the 2004 filing season. The IRS will ask 25,000 EITC claimants (down from the 40,000 proposed earlier) to certify when they file that the eligible child claimed for EITC purposes resided with them for more than half a year as required by law. First notices will be going out shortly before year's end. The goal will be to make the forms easier to understand and to ensure participation in the program. In addition, the IRS also announced it would maintain a sustained level of compliance activities by expanding efforts to reduce erroneous payments to taxpayers who underreport their income in order to claim the credit. Next year, the IRS will expand its compliance efforts involving at least 300,000 taxpayers who claim the credit but failed in the past to report all of their income. These taxpayers may not be eligible because the EITC has an income cap. This group will also include EITC claimants who misrepresent their filing status. Following the 2004 certification pilot, the IRS will carefully assess the pilot results and performance before deciding on how to proceed with the program.
The IRS has issued proposed regulations (REG-133791-02)relating to the computation and allocation of the credit for increasing research activities for members of a controlled group of corporations or a group of trades or businesses under common control. These proposed regulations reflect changes made to section 41 by the Revenue Reconciliation Act of 1989 and the Small Business Job Protection Act of 1996, which introduced the alternative incremental research credit.
In a series of revenue procedures the IRS has provided sample annotated trust agreements for charitable remainder annuity trusts under various scenarios:
Rev. Proc. 2003-53, IRB 2003-31; CRAT for one measuring life
Rev. Proc. 2003-54, IRB 2003-31; CRAT with a term of years annuity period
Rev. Proc. 2003-55, IRB 2003-31; CRAT with consecutive interests for two measuring lives
Rev. Proc. 2003-56, IRB 2003-31; CRAT with concurrent and consecutive interests for two measuring lives
Rev. Proc. 2003-57, IRB 2003-31; CRAT for one measuring life
Rev. Proc. 2003-58, IRB 2003-31; CRAT with a term of years annuity period
Rev. Proc. 2003-59, IRB 2003-31; CRAT with consecutive interests for two measuring lives
Rev. Proc. 2003-60, IRB 2003-31; CRAT with concurrent and consecutive interests for two measuring lives
In Notice 2003-57 (IRB 2003-34) the IRS announced that taxpayers with interests in certain Canadian retirement savings plans, as well as the custodians of such plans, required to file Forms 3520 and 3520-A have an automatic extension until August 15, 2003 to file the forms for 2002. The IRS also announced that it is considering establishing for future taxable years a simplified reporting regime for Registered Retirement Savings Plans (RRSPs) and persons with interests in RRSPs and coordinating the reporting requirements with the election described in section 4 of Revenue Procedure 2002-23.
In Theresa L. Lamplugh (2003-2 USTC 50,549; U.S. Court of Appeals, 3rd Circuit) the IRS appealed a District Court ruling that granted the taxpayer a new trial because of the alleged ineffective assistance of her trial counsel. The Court of Appeals reversed the lower court, holding that by providing her attorney with fraudulent documents that she intended to be used at trial to create a reasonable doubt of guilt, the taxpayer forfeited her right to claim ineffective assistance of counsel.
The IRS normally charges interest on underpayments and late payments. You can request an abatement of the interest. In Raymond W. Beall, Hazel A. Beall (2003-2 USTC 50,551; U.S. Court of Appeals, 5th Circuit) the Appeals Court reversed a District Court's decision to dismiss the taxpayer's claim for a refund of interest. The Appeals Court found that Congress did not give the Tax Court exclusive jurisdiction over such issues. The Court remanded the case back to the District Court.
You may be able to escape liability for your spouse's tax problems, but you've got to meet certain criteria and claim innocent spouse relief. Among the requirements are that you did not know of the problems and that you did not benefit. In Marc S. Feldman (T.C. Memo. 2003-201) the Court sided with the IRS in finding that the taxpayer had constructive knowledge of the deficiencies. The taxpayer was well educated and earned significant income. The taxpayer let his wife take care of their financial affairs. She presented him with ledger sheets and documentation of investments that contained what the Court felt were obvious inconsistencies. In addition, the Court noted that the tax return contained obvious errors that the Court felt the taxpayer should have noticed.
In Dale H. and Edith Littlefield Sundby (T.C. Memo. 2003-204) the taxpayers tried to claim a bad debt deduction for loans made between two C corporations where the taxpayers were the sole shareholders in each. The Court first held that a bona fide debt did not exist, for several reasons, but importantly because the loan was not an arms' length transaction. But even if the debt were bona fide, the taxpayers would not be entitled to the deduction, it would be deductible, if at all, by the corporation.
In Curtis B. Keene (121 TC--, No. 2) the Tax Court held that a taxpayer was entitled to make an audio recording of his collection due process hearing with the IRS Appeals Office. The Court found the taxpayer gave the IRS the required advance request to record. However, in George R. Kemper et ux. (T.C. Memo. 2003-195), Virgil and Joyce Brashear (T.C. Memo. 2003-196), and Albert Horton and Ramona Osborne (T.C. Memo. 2003-197) the Court rejected the taxpayers' challenges of adverse collection due process determinations on the grounds that they were not allowed to make an audio recording of the hearing.
The IRS has issued proposed regulations (REG-208199-91) regarding the use of designated summonses and related summonses and the effect on the period of limitations on assessment when a case is brought with respect to a designated or related summons. These proposed regulations reflect changes to Section 6503 made by the Omnibus Budget Reconciliation Act of 1990 and the Small Business Job Protection Act of 1996. This regulation affects corporate taxpayers that are examined under the coordinated issue case (CIC) program and are served with designated or related summonses. This regulation also affects third parties that are served with designated or related summonses for information pertaining to the corporate examination.
Get it in writing. That's always good advice. But in John and Donnal Ringgold (T.C. Memo. 2003-199) the taxpayers thought their oral offer in compromise was accepted by the IRS. However, the auditor thought the offer was only for additional time to pay. The Court noted that the law regarding compromises is well established. The regulations and procedures under section 7122 provide the exclusive method of effectuating a compromise. It held taxpayers and the IRS did not enter into a binding agreement to compromise taxpayers' liability. First, taxpayers did not submit Form 433-A for the IRS to determine whether there was doubt as to collectibility. Second, taxpayers did not submit an offer in compromise on the appropriate form (i. e., Form 656), and were never notified in writing that an offer in compromise had been accepted. Finally, there was no mutual assent because the auditor misunderstood the nature of petitioners' request.
While reasonable compensation issues may not be as frequently encountered because of recent changes in the tax law, the issue certainly won't disappear. In Brewer Quality Homes, Inc. (T.C. Memo. 2003-200) the Court found that the taxpayer's appropriate compensation was more than allowed by the IRS, but less than that claimed by the taxpayer. The Court considered the usual factors, but also looked to the Robert Morris Associates (RMA) report for the industry on financial ratios, which provides data on, among other things, executive compensation as a percentage of sales for companies comparable to the taxpayer. Based on taxpayer's and the mobile home retail industry's financial performances in 1995 and 1996, the Court concluded that the president's compensation as a percentage of sales should be compared to those of executives in comparable companies at around the 90th percentile. By multiplying taxpayer's sales by the appropriate RMA factor for each year, the Court determined that payments to the president, as compensation, would have been about $520,000 in 1995 and $600,000 in 1996.
Previously Reported In Daily Update
Know what you're invested in . . . Banks, brokers, and other financial institutions are constantly generating fancy new investment vehicles. Some are good ideas, many aren't. Many are just a way to shift risk from the bank or broker to customers. There's often a surge in new products when there's a market frenzy or boom in the economy, but they can happen anytime. The old adage, "if you don't understand the investment, stay out of it" works most of the time. No matter what anyone says, there is no sure thing. Another truism is that the higher the reward, the higher the risk. If your money market fund is yielding 5% when most are at 2%, your fund has got to be investing in riskier vehicles. There's nothing wrong with that if you're aware of it and are ready to assume that risk. Read the prospectus for your investments.
Check zoning before buying or renting commercial property . . . Zoning rules vary widely. In some small towns they're lax. In many suburban communities they can be very strict. Check carefully before buying or committing to a long-term lease. And plan ahead. Are you really going to be limiting your activities to retailing? You may now be running a bakery and selling all your products to in-store customers. But would you be in violation if you shipped products to other stores? Some towns hold that is a wholesale activity and thus not allowable under the zoning rules. Or you now distribute electronic components. You decide to expand into assembling computers using just a few standard modules. That could be light manufacturing. Check parking rules too. Many towns have strict rules on the square footage of the store relative to the number of parking spots. If you're at the limit, you may not be able to expand the size of your store or restaurant because there's no room to expand the parking lot. While you're at it, check your lease too. Your lease may restrict you to a retail operation; light manufacturing could be prohibited.
Not invented here? . . . Some companies never buy or license products designed elsewhere. Some take the opposite tack. They never invent their own. There's no best approach here. If you have no engineers or designers but simply distribute products from others, you're taking a risk of not having competitive products in the pipeline. Designing everything increases your R&D budget, reducing your margin. What's the best approach? There's no one answer. It depends on the industry and how you manage your business. Some companies have succeeded because they can always come up with the latest technological advance; others in the same industry do well because they're particularly efficient at manufacturing or marketing. Analyze your strengths and weaknesses carefully.
Not all search engines created equal . . . If you're just looking for a web site, say on business taxes, you can pretty much go to any search engine and type in "business taxes". (You'll find, in most cases, we're the first unsponsored site.) But what if you're looking for something much more specific? For example, if you're looking for a particular section of labor law, you might type in "29 CFR 2570". Google.com and some other search engines will find references to the section and the actual section on the Department of Labor site, but many other search engines will draw a blank.
Rent or buy? . . . If you need a piece of small equipment for just a day or two, renting may make more sense than buying. You'll save money and improve cash flow. And, for tax purposes, rental expenses can be deducted immediately; equipment purchases may have to be written off over a number of years. But at some point, buying (or leasing) becomes more attractive. When? With small equipment (e.g., small power tools) the 4th time you go back to rent is often about the breakeven point. On larger equipment, you can rent for more times or longer periods and still come out ahead. Thus, renting some construction equipment might be $300 per day, but the equipment would cost $20,000 to purchase. To find the breakeven point, divide the cost of purchasing the equipment by the cost of a daily rental. That's the breakeven point in days. For example, if the unit would cost $500 and it rents for $50 per day, the breakeven is 10 days. Rent for longer and you would have come out ahead by buying. Here are some other thoughts:
Blackout period notice . . . If you have pension plan for your employees, and plan participants may be unable to direct or diversify assets, obtain plan loans, or receive distributions from the plan for more than three days, you have to provide notice to the employee at least 30 days, but not more than 60 days in advance of the blackout period. There are penalties for failure to provide notice. You can obtain a sample notice from your plan sponsor. If you're the only participant, you don't have to provide notice. But, if you have just one employee, you must do so.
Use premiums instead of discounts . . . Why? It's often cheaper. That's not the only reason, but it's a good one. Your customer will think he or she is getting a $25 item free. However, that item may only cost you $10, maybe much less. To get the same effect from a product discount you'll have to offer $25 off. That's $25 less profit versus only a $10 cost for the premium. Worse yet, you may have cheapened your product in the eyes of the customer. That can mean you'll have to give a discount in the future to generate sales. Don't make the mistake of charging for the premium, however. If you can't give it away, it's generally best to use another option. The premium doesn't have to be related to the product or service you're trying to sell. The most important point is that it should be perceived as valuable to the customer.
Rent too high? . . . Rents tend to follow local market action. While rent in a major mall is likely to be much higher than retail space in a sleepy downtown location, you can't shop just based on price. Some businesses, such as convenience stores, fast food eateries, ice cream parlor, etc. require high traffic. You'll probably have to pay more for the location, but it should be worth it in the long run. On the other hand, specialty stores such as high quality clothing, specialty tools, bookstores, while they may do better in such locations, usually don't need them to thrive. The type of customers such stores attract will probably seek them out. Sometimes customer needs are paramount. If your customers are business people, convenient parking may be a critical factor.
Make sure business is expandable . . . Specializing in a small niche can be a path to success for a small business. But before committing to a product or service, make sure there's enough of a market to succeed. And don't forget to consider that you may be limited geographically. Even if there is enough market, can you expand into other product lines or services later without altering the identity of the firm?
What impacts your credit rating? . . . If you think your credit rating is affected only by how you pay your credit card bills and if your mortgage payments are on time, think again. Late payments to your homeowner's insurance, telephone and utility company, etc. can have a negative impact. Some nonfinancial companies have a policy of not reporting late payments, but a large enough percentage do to make it prudent for you to keep current on all your bills. Sometimes, even paying anything less than the full amount can impact your rating. The same is true for your business credit. It's not just suppliers or subcontractors who report your payment history.
Copyright 2003 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