Small Business Taxes & Management

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

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

News On The Tax Front

Previously Reported In Daily Update

If you use part of your residence for business purposes (and qualify under the rules), you can deduct a portion of the expenses of maintaining the residence. If you rent, you can deduct a portion of the rent you pay. In Michael H. Visin and Natalie Marselly (T.C. Memo. 2003-246) the taxpayers claimed a deduction for a portion of their rent. However, the portion of the rent deducted generated a loss by the business. The Court held that the law is clear that a deduction for a portion of the dwelling unit cannot reduce the gross income from the business below zero. Thus, part of the deduction for rent was disallowed. The Court noted that the taxpayers could carryforward any portion of the rent not used in the year at issue. In the same case, the taxpayers tried to expense computer equipment purchased during the year. The Court noted that the only way the taxpayers could expense such equipment was by making a Section 179 election on his tax return. The Court also noted that the taxpayers did not include Form 4562, on which the election would be made, with their return. Without making the election on Form 4562, the deduction was disallowed. Note. Making the election is generally easy. Don't make the mistake of not doing so.

The IRS can generally audit your return up to 3 years from the date you file it. (The rule is actually more involved and there's no limit if there's fraud.) Most states use the same time limit. But if you don't file a return, the statute doesn't start to run. In Jimmy A. Prince (T.C. Memo. 2003-247) the Court held the IRS mailed the deficiency notice within the 3-year period from the date the taxpayer actually filed the return.

A number of IRS rules turn on the filing of a valid tax return. In William R. Duren (T.C. Memo. 2003-242) the taxpayer claimed a deficiency notice wasn't mailed to his last known address. (As a result, the notice was received after the deadline for filing a challenge.) The rule is the IRS will use the address on the taxpayer's "most recently filed return" is the return which has been properly processed by an IRS service center. The Court noted the taxpayer failed to sign the return. Thus, the return was not valid and was not processed by the IRS. The Court held the IRS properly used a prior address. A letter sent by the taxpayer notifying the Service of his change of address was not adequate because it did not provide clear notification of the address change. If you're changing your address, use IRS Form 8822, Change of Address.

The IRS may allocate gross income, deductions and credits between or among two or more taxpayers owned or controlled by the same interests in order to prevent evasion of taxes or to clearly reflect income of a controlled taxpayer. Comprehensive regulations under Sec. 482 were published in 1968 and provided guidance with respect to a wide range of controlled transactions, including transfers of tangible and intangible property and the provision of services. Revised and updated transfer pricing regulations were published in July 1994, December 1995, and May 1996. The proposed regulations (REG-146893-02 and REG-115037-00) provide guidance regarding the treatment of controlled services transactions under Section 482 and the allocation of income from intangibles, in particular with respect to contributions by a controlled party to the value of an intangible that is owned by another controlled party. The proposed regulations provide updated guidance that is necessary to reflect economic and legal developments since the issuance of the current guidance.

Section 45D provides a new markets tax credit on certain credit allowance dates with respect to a qualified equity investment in a community development entity (CDE). The IRS has announced Notice 2003-64 (IRB 2003-39) it will amend the definition of a qualified low-income community investment under Sec. 1.45D-1T(d)(1)(iv) of the temporary regulations to include investments through two additional qualified CDEs. In response to comments, Sec. 1.45D-1T(d)(1)(iv) will be amended to include investments through two additional CDEs by providing that the term "qualified low-income community investment" includes any equity investment in, or loan to, any CDE (the second CDE) by a CDE (the primary CDE), but only to the extent that the second CDE uses the proceeds of the investment or loan for certain enumerated purposes.

Corporations and individuals can claim a net operating loss (NOL) carryback or carryforward and reduce their tax liability for prior and future years. In Allan and Judy N. Green (T.C. Memo. 2003-244) the Court sided with the IRS noting that the taxpayers did not establish the composition of the NOL carryovers, did not substantiate the existence, amounts and years of the NOLs, that any of the amounts incurred before the year at issue were properly applied to the year at issue, and that the NOL is still available for use (NOLs can be carried back 2 years and forward 20 years).

The law allows a business taxpayer a Disabled Access Credit of up to 50% of the cost of expenditures to make a business accessible to disabled individuals. The credit can't exceed $5,000. For many businesses the credit may be generated by the expenditure for a wheelchair ramp, special drinking fountain, etc. In David B. Hubbard and Janis Hubbard (T.C. Memo. 2003-245) the taxpayer was an optometrist who purchased special equipment that increased his ability to treat disabled patients. The Court allowed the taxpayer a credit for the equipment. It noted that the fact that the automatic refractor was also used by the taxpayer to treat nondisabled patients was not fatal to his entitlement to the disabled access tax credit. The Court contrasted it's decision with that of Fan. In that case, prior to purchasing the equipment the taxpayer was already in compliance with ADA through the use of other methods. Here, the taxpayer was unable to treat the patients without the equipment.

Capital contribution or taxable income? If payments to an entity are made in exchange for an ownership interest, the amount is a capital contribution and nontaxable. If they are not for an equity interest, the amounts could be taxable income to the entity. In MAS One Limited Partnership (2003-2 USTC 50,609; U.S. District Court, So. Dist. Ohio, East. Div.) the Court found the $8.3 million payment was from a former partner in the partnership. The payment was not for a new interest in the partnership, but a payment to allow the former partner to abandon its partnership interest. Thus, the amount was taxable income.

The IRS has announced a new centralized toll-free number for the e-Help desk that supports IRS e-file, Electronic Federal Tax Payment System (EFTPS), TeleFile and future e-services customers. The new number, 1-866-255-0654, is available at different times at different locations and the times change during different (peak vs. non-peak) times of the year. During peak times (November through April 15) some of the centers will be available on Saturdays. The number is generally available earlier in the day (some centers open as early as 7:00 A.M.) but also generally close early.

The IRS has issued revised temporary regulations (T.D. 9090) to provide guidance regarding the use of a nonaccrual-experience method of accounting by taxpayers using an accrual method of accounting and performing services. The revisions reflect changes to section 448(d)(5) of the Code by the Job Creation and Worker Assistance Act of 2002. The revised temporary regulations will affect taxpayers that no longer qualify to use a nonaccrual-experience method of accounting, and qualifying taxpayers that wish to adopt or change a nonaccrual-experience method of accounting.

Not too long ago the tax law was changed to include damage awards as taxable income unless they for damages for physical injury or sickness. In Sandra G. Venable (T.C. Memo. 2003-240) the taxpayer argued that the rule didn't apply because you began her suit before the law was enacted. The Court noted that she received the award after the law had changed. The Court also noted that since the change in the law was technically an increase in tax, rather than a new tax, the application of the new law retroactively was not unconstitutional.

The General Services Administration (GSA) has announced the fiscal year 2004 maximum per diem rates for locations within the continental U.S. (CONUS). These are the same rates published by the IRS for use by taxpayers claimed the per diem allowance rather than actual expenses for travel. The allowance for incidental expenses for all localities has been increased from $2 to $3. The per diem rates can be found in Bulletin 04-1, at www.gsa.gov/perdiem. It's anticipated the IRS will shortly issue the same information in detailed form and the high-low rates.

The IRS has issued proposed regulations (REG-108524-00) regarding the obligation of a partnership to pay a withholding tax on effectively connected taxable income allocable under Section 704 to a foreign partner. The regulations will affect partnerships engaged in a trade or business in the U.S. that have one or more foreign partners.

The IRS has issued temporary regulations (T.D. 9089; REG-132760-03) that provide rules for reducing tax attributes (e.g., net operating losses, tax credit carryovers) when the debt of a member of a consolidated group is forgiven. The discharge of indebtedness is generally income to a debtor corporation. There is an exception to this rule when the debtor corporation is in bankruptcy. In lieu of including the amount of discharged debt in income, the bankrupt corporation must reduce its tax attributes by the amount of debt discharged. The reduction of attributes prevents corporations from avoiding taxable income in bankruptcy while retaining tax attributes that can reduce future tax liability. Because consolidated attributes could later be used to reduce the tax liability of the bankrupt member, the temporary regulations clarify that all of the consolidated attributes of the group are available for reduction when the debt of a member of the group is discharged. In addition, they provide a methodology for reducing attributes.

The IRS has issued guidance (ILM 200335034) regarding the tax consequences of settlement payments received for lost fishing income and for the devaluation of fishing licenses and boats.

If you do business as a regular corporation, the IRS can disallow some of the compensation of officer/shareholders as unreasonable. That makes the disallowed amount nondeductible, but still income to the recipient as a dividend. While these cases are not as prevalent as in the past, they can still be troublesome. In E.J. Harrison and Sons, Inc. (T.C. Memo. 2003-239) the corporation paid the wife of the ex-president and founder between $600,000 and $860,000 for the years at issue. The IRS allowed only $58,000 to $54,000 as a deduction, claiming the rest to be unreasonable. The Tax Court looked at a number of issues including the return on sales, return on yearend equity, and return on yearend assets, as well as the time spent and services performed by the wife, and the internal consistency of salaries (salaries paid to officer/shareholders vs. salaries paid to nonshareholder employees). The Court allowed between $98,000 and $106,000 as salary for the years at issue.

The IRS announced (IR-2003-108) over-the-counter drugs can be paid for with pre-tax dollars through health care flexible spending accounts. The IRS issued guidance clarifying that reimbursements for nonprescription drugs by an employer health plan are excluded from income. Thus, reimbursements by health flexible spending arrangements (FSAs) and other employer health plans for the cost of over-the-counter drugs available without prescription are not subject to tax if properly substantiated by the employee. Revenue Ruling 2003-102 explains that the statutory exclusion for reimbursements of employee health expenses is broader than the itemized deduction for medical expenses (which does not apply to nonprescription drugs). Thus, the guidance clarifies that employer reimbursements of employee health expenses that are nonprescription drugs, including reimbursements through health FSAs and Health Reimbursement Arrangements (HRAs), are excluded from income like other employer reimbursements of employee health expenses. This will result in savings to consumers with access to employer plans who may purchase nonprescription drugs. However, for purposes of the itemized medical expenses deduction, the cost of such over-the-counter drugs continues to be non-deductible. In addition, the cost of dietary supplements that are merely beneficial to the employee's health are not excluded from income.

Because a lien attaches to all property owned at the time of assessment, the IRS must demonstrate that a taxpayer owned the property at the time the tax deficiencies were assessed. In Marie M. Abbott (2003-2 USTC 50,603; U.S. District Court, Dist. Nev.) the Court noted that, from the deed attached to the Service's motion, that the taxpayer was the owner and in possession of the property at the time of the assessment and that foreclosure and sale of the property at auction was proper.

Taxpayers have been trying to convert ordinary income into capital gains for as long as there has been a lower rate on capital gains. There is probably now more incentive than every to do so since the rate differential is larger than it has been in some time. In Warren L. Baker, Jr. and Dorris J. Baker (2003-2 USTC 50,604; U.S. Court of Appeals, 7th Circuit) the taxpayer argued that a termination payment he received from an insurance company for which he was an agent was actually for the sale of the goodwill of his business and should be taxed as a capital gain. The Court did not agree. It noted that he did not own any of the business assets and that the payment was taxable as ordinary income.

In most tax cases the burden of proof is on the taxpayer. But not if the IRS claims fraud. In such cases the Service has to show by clear and convincing evidence that the taxpayer intended to fraudulently evade taxes. That's not easy. In Stephen C. Carter (T.C. Memo. 2003-235) the IRS was unable to meet that burden. To the contrary, the taxpayer established that he did not intend to evade tax, but was negligent and inattentive regarding his record keeping and tax filing obligations. The taxpayer relied on his CPA to accurately prepare his returns and believed that the travel and entertainment expense reimbursements had been taken into account. Since the IRS could not show fraud, the statute of limitations remained at 3 years.

In Kathi Cooper, Beth Harrington, and Matthew Hillesheim (2003-2 USTC 50,596; U.S. District Court, So. Dist. Ill.) the Court found that IBM violated the age discrimination provisions when it adopted a pension equity plan and then converted to a cash balance plan from a defined benefit plan.

If you want to prove you mailed anything to the IRS, send it registered or certified mail. In Marilyn L. Moore (2003-2 USTC 50,599; U.S. District Court, Mid. Dist. Fla., Tampa Div.) the Court held that the taxpayer's return and a claim for refund were not timely filed where she could not prove the items were mailed. The Court noted that entries in a personal journal stating the return the items were filed were not sufficient proof.

You can deduct the cost of a professional tax preparer and the cost of materials (software, books and manuals, etc.) to prepare your tax return. (These are deductible as a miscellaneous itemized deduction.) But what about the cost of going to the library, tax preparer, etc. In Dieter Stussy (T.C. Memo. 2003-232) the taxpayer drove 275.1 miles for which he claims a miscellaneous itemized deduction at the standard mileage rate. The breakdown of these miles was: 165.5 miles for petitioner's copying and filing of his personal federal and state income tax returns, 82.7 miles for meetings with IRS personnel related to the examination of his personal income tax returns, 14.5 miles for petitioner's trip to the Santa Monica law library, and 12.4 miles for petitioner's copying of a document entitled "Response to AG of IRS Investigation". The Court allowed the amounts as expenses incurred in connection with the determination, collection, or refund of any tax. The Court disallowed the taxpayer's claimed deduction of charitable contributions because he did not have the requisite substantiation for amounts in excess of $250.

In William G. Wells (T.C. Memo. 2003-234) the taxpayer sought a review of the Service's determination to proceed with the collection of tax on his 1991 and 1992 liabilities. The taxpayer had an installment agreement, but, because of an unexpected reduction in rental income, ceased making the installment payments. The taxpayer argued that the Service had abused its discretion in not renegotiating and reinstating the installment agreement. The Court found the taxpayer had been given a reasonable time to provide his financial information or an offer-in-compromise. There was no evidence to suggest the taxpayer's earlier stroke and hearing loss made him physically unable to compile his financial records or assist his attorney.

In Rev. Proc. 2003-72 (IRB 2003-38) the IRS announced it is extending until January 31, 2003 the deadline for applying for determination letters for certain pre-approved qualified retirement plans (that is, master and prototype and volume submitter plans). A plan is eligible for this extension only if the plan's GUST remedial amendment period ends on or after September 30, 2003, and before January 1, 2004, and either (i) the plan is amended to comply with GUST within the plan's GUST remedial amendment period, or (ii) a compliance fee of $250 is paid with the determination letter application. This revenue procedure also extends the time by which defined contribution plans must be amended to comply with final and temporary regulations under Sec. 401(a)(9), relating to required minimum distributions, until the later of the end of the first plan year beginning on or after January 1, 2003, or the end of the GUST remedial amendment period. The time by which defined contribution plans must be amended to comply with the final and temporary regulations under Sec. 401(a)(9) is extended to the later of the last day of the first plan year beginning on or after January 1, 2003, or the end of the GUST remedial amendment period. This does not extend the December 31, 2003, deadline for sponsors of pre-approved plans to amend their defined contribution plans and, in the case of master and prototype plans, furnish copies of the amendments to adopting employers.

In Brief:

Previously Reported In Daily Update

What's the penalty for late filing an S corporation return? . . . Penalties for returns that have tax associated with them (your individual return, a C corporation return) are usually based on the amount of tax due. But S corporations usually don't pay tax on their own (S corporations can owe some special taxes). Instead, the income is passed through to the shareholders and reported on their returns. The IRS provides some special penalties for late filing an S corporation return. The minimum penalty for filing a return more than 60 days late is the smaller of the tax due or $100. In addition, for failing to provide a Schedule K-1 to a shareholder when due (and for each failure to include information required to be shown on the K-1) a $50 penalty may be imposed for each K-1. If the require to report correct information is intentionally disregarded, each $50 penalty is increased to $100 or, if greater, 10% of the total amount of items required to be reported.

Changing your state of incorporation? . . . You could dissolve the corporation in the state you're in now and contribute the assets to a new corporation you start in the new state. That, however, can have major tax consequences. Tax law provides an alternative. The technical term is an "F" reorganization. Basically, it involves setting up a new corporation in the new state and merging the old corporation into the new. It sounds complicated, but it really isn't. Any corporate lawyer should be able to handle the transaction. While there are no federal tax consequences, check the tax rules in the states involved. And you'll have to include a statement and copies of the articles of merger with the return for the year the transaction occurs.

Outsource before hiring . . . It definitely appears the economic recovery is in progress. But there's always a chance of a setback and even if the recovery goes unabated, you might want to be careful in your hiring. You don't want to add an employee only to have him idle should things slow down or not pick up as quickly as you anticipated. You might want to outsource one job for every two you have. That is, if you need to add two employees, outsource one of the jobs and hire an employee for the other. Also, consider other costs. The cost of an additional employee is much more than his or her salary. In addition to FICA and benefits, there's the cost of office space, etc.

Capacity utilization increasing . . . One of the reasons prices have been under control is that many manufacturers and even many service businesses have excess capacity. That's starting to change. Little additional capacity has been added recently and some old capacity has even been retired. This is starting to translate into a reduction in excess capacity. Don't be surprised if you start to see price increases in certain areas.

Change in assets may necessitate change in will . . . Some wills are very simple. You're a widower, all your assets are in your own name and you specify that half your estate will go to your son, half to your daughter. If that's it, you probably will never have to revise your will (unless one of the beneficiaries dies). But what if, after signing the will you open a joint account (with right of survivorship) with your daughter, depositing $100,000 so that she can take care of you should you become unexpectedly ill? Or you name your son as a beneficiary of your life insurance? Your estate will no longer be split 50-50. If that's the intended result, that's fine. If not, you may have to change your will or take other steps to equalize the estate. The same thing can happen if you leave a specific asset to one of your heirs, for example, your rare coin collection, and sell it before you die. If the asset is not in the estate, the beneficiary just doesn't get it. What to do? Review your will regularly. And be sure to review it after making significant changes in the ownership of your assets.

Credit card fraud statistics . . . Some statistics put credit card fraud from traditional (e.g., in-face purchases at a store) purchases at about 0.1%. On the other hand, purchases made over the phone, through a website, etc. generate fraud rates of 2.1%. Most of the problems arise from new customers, not repeat customers with which you've got an ongoing relationship. Check out new customers carefully, particularly if they want express shipping, are making an unusually large order, have different ship-to and billing address, etc.

Work the statistics . . . You may have lived in the same house for 25 years. That's not unusual. But the statistics indicate that just over 15% of the U.S. population moves annually. Clearly, some people are moving very frequently. Don't rely on intuition to plan your business. If your business is consumer-oriented, make sure you factor that movement into your marketing plans. You may even want to buy a list of new homeowners or individuals moving into your market. Depending on your business, it can be a great source of new customers.

How's the health of your life insurance carrier? . . . Maybe not as good as you thought. Some name companies are in trouble because of investments, poor decisions with respect to annuities, etc. You should always check on the strength of the company periodically, but now is a critical time for many policy holders. Five companies rate the financial strength of insurance companies:

A.M. Best                     www.ambest.com
Fitch Ratings                 www.fitchratings.com
Moody's Investors Services    www.moodys.com
Standard & Poor's             www.standardandpoors.com
Weiss Ratings                 www.weissratings.com

What's in a name? . . . Sometimes, plenty. Companies often drop product lines, change names, go out of business, etc. and either don't sell the name, or sell it for a nominal amount. That name can be valuable, even if it hasn't been used for years. For example, Eastern Airlines went out of business some years ago (we don't know if anyone bought the name). If you bought and used the name for a similar service, you'd get some instant recognition. Of course, you target market should be individuals who heard or flew on the airline. That rules out those younger than about 25, but just about anyone older should qualify. And, in many cases, the product or service doesn't have to be the same. For example, Tom Field may have been the name on a line of quality shotguns, but you could use it for hunting apparel, camping equipment, etc. You may be able to pick up an old name for next to nothing. What about the flip side? If you've got a name that's been in use for a while, even if only locally, and you're selling or just liquidating the business, don't ignore the value of the name. You may be able to get a significant amount for it, even if your business no longer exists.