Small Business Taxes & Management

The IRS is changing its web address. The new address will be simply www.irs.gov. The old address will continue to work.

If you're setting up or administering a qualified retirement plan you've got to be careful to dot the i's and cross the t's. Some minor mistakes, such as failing to provide notice to the employees, can disqualify the plan. But in the case of Frank A. Sonier (T.C. Memo. 1999-275) the Tax Court sided with the taxpayer. The rule is that a plan participant can request the Tax Court to issue a declaratory judgment if there is an actual controversy with respect to the IRS's issuance of a determination letter. Here the Tax Court found that the plan participant did receive notice of the plan and that his complaint about the rate of return of the plan was unfounded. Note. While the taxpayer won this case, you've got to be careful. Get competent advice. The loss of qualified status of a plan can be very costly.

In Notice 99-44 the IRS has provided guidance on the repeal of the combined plan limits on plan benefits and contributions that's effective for years beginning on or after January 1, 2000.

When you claim a casualty loss you can't just list all the assets damaged or destroyed as one item on your tax return. You've got to prove both the adjusted basis of each single, identifiable property damaged or destroyed and the diminution in value of the property as a result of the casualty in order to get a deduction for the claimed loss. That's what the Tax Court ruled in Trinity Meadows Raceway, Inc. (99-2 USTC 50,754; U.S. Court of Appeals, 6th Circuit).

Capital gains on real property can be taxed at two rates-- 20% (or 10% for taxpayers in a low bracket) on regular gains and 25% on depreciation recapture. Now, the IRS has just issued regulations on how to handle the two rates if the property is sold by way of an installment sale. Basically, all the 25% gain is reported and taxed first. Only then is the 20% (or 10%) gain reportable. In addition, where there is an installment gain that is characterized as ordinary gain under section 1231(a) because there is a net section 1231 loss for the year, the gain is treated as consisting of 25% gain first, before 20% gain, for purposes of determining how much 25% gain remains to be taken into account in later payments.

In a recent issue we discussed the problem of limiting the transfer of shares in a closely held corporation, particularly an S corporation. In a recent letter ruling (LR 199935035) 2 minority shareholders transferred stock in an S corporation to a C corporation they owned. They did so in violation of a cross purchase agreement they had signed that required them to give notice to the other shareholders and provide an opportunity for them to purchase the stock before a sale to outsiders. The majority shareholder in the S corporation filed suit and a state court declared the attempted transfer void from its inception. Because the state court ruled the transfer void, the IRS held that the S status of the corporation was never violated. Had it not been for the cross purchase agreement, the corporation's S status would almost assuredly have been terminated.

The IRS scrutinizes legal fees, knowing that all or a portion can often be disallowed entirely or may have to be capitalized. In Sklar, Greenstein & Scheer, P.C. (113 TC- -, No. 9) the IRS disallowed legal fees incurred when the taxpayer corporation's qualified defered compensation plan and shareholders sued the manager of the securities account. The corporation was allowed to deduct the portion of the legal fees that were allocable to the qualified plan. Fees that were allocable to the shareholders were held by the Court to be nondeductible.

Double jeopardy means you can't be tried twice for the same crime. However, that doesn't mean you can't be tried and convicted under the criminal statutes and tried and convicted again under the civil statutes. That's what happened in James C. Dunkel (99-2 USTC 50,737; U.S. Court of Appeals, 7th Circuit). The taxpayer was convicted of criminal tax evasion and then the IRS imposed civil fraud penalties on top of that. The Court did not overrule the Service's position.

If you pay for disability insurance with after-tax dollars, any proceeds you receive are not taxable. If your employer pays the premiums, any proceeds are fully taxable. There's an exception. If the policy payout is based on the nature of the disability rather than the loss of income or the length of the disability, the proceeds are not taxable. That was exactly the case in Jon L. Stolte and Esther J. Stolte. The taxpayer was a surgeon who lost the use of his legs, hands, and feet as the result of a physical condition. Note. This may be one way to have your company pay your disability premiums while avoiding income on the proceeds. Refer your tax advisor to IRC Sec. 105(c).

It would be nice to be able to deduct expenses associated with a hobby, recreation activity, etc. But the IRS is on always on the lookout for such deductions. In William Allen Simpson (T.C. Memo. 1999-274) the Tax Court denied the taxpayer a deduction for flying lessons. The Court found the taxpayer couldn't show the relevance to his business as a self-employed computer consultant.

Sometimes even the largest companies make big mistakes. In the case of United Parcel Service of America, Inc. (T.C. Memo. 1999-268) the company organized an insurance company to take insure the company's liability for damaged packages. One of the rules is that in order to deduct premiums paid to an insurance subsidiary, there must be a significant shifting of risk. The Court found that did not occur. It found the insurance operation to be a sham. The taxpayer tried to show that there were substantial business reasons for the insurance subsidiary. The Court examined that argument carefully and did not side with the taxpayer.

The rule is that the statute of limitations doesn't start running until you file a valid tax return. In Herbert C. Elliott (113 TC--, No. 7) the Court found that the taxpayer filed an unsigned tax return. The return was signed by the taxpayer's attorney, but he did not have a valid power of attorney. Note. Most states take the same approach. For example, you've been doing business in a state for 15 years, but have never filed a sales tax return. The state may be able to collect back taxes from the day you first began doing business in the state.

In Ivan and Betty Lee Turner Gati (113 TC--, No. 8) the taxpayer filed a request for an abatement of interest on a tax deficiency. A taxpayer has only 180 days from receiving a final determination letter to request an abatement. Because the taxpayers did not notify the IRS of an address change, the IRS notice sent to them was delayed and the taxpayers filed the request for abatement 6 days late. The Court denied the taxpayers any relief.

Just because the contract calls the transaction a lease doesn't mean the IRS recognizes the deal as a lease. It may be considered a conditional sale. In Harry E. Peaden, Jr. and Cindy D. Peaden (113 TC--, No. 6) the taxpayers leased vehicles under a lease that contained a terminal rental adjustment clause (TRAC). The IRS contended that the TRAC made the deal a conditional sale. The Court found that the TRAC could not be considered when deciding on whether the transaction was a lease or conditional sale.

You may be able to escape the negligence penalty if you can show that, in good faith, you relied on professional advisors. For example, you used a professional tax preparer to do your return. But you've got to give the professional both accurate and complete information and you must be able to show that you did not act in a careless or reckless manner. In Shane Michael Optical, Co. (T.C. Memo. 1999-267) the taxpayers were able to show they followed the rules. While they owed additional tax, they were not liable for the negligence penalty.

Penalty Waivers on Information Returns

Even the most conscientious taxpayer will occasionally forget to file a return, file late, provide incorrect information on the return, etc. If that happens, you can expect a notice from the IRS (and, in many cases, your state). Some penalties can be waived, some can't. But don't automatically pay the penalty. The article below details some of the possible ways to get the penalty waived if you file 1099s, W-2s, and other information returns late or fail to comply with the magnetic media requirement. (If you have to file more than 250 of a type of return, e.g., W-2, you have to file the returns on computer disk.)

Penalties. The penalties for failure to file information returns can be steep, as much as $50 per return. For example, you have 35 1099s to file. The bookkeeper forgets to file them until September. The IRS will assess a penalty of $1,750. (If the IRS believes the failure to file is intentional, the penalty can be $100 per return.) The penalty can also be assessed for failure to include all the required information.

The penalty is graduated; 1099s are due to the IRS on February 28. If you file, or the error on the 1099 is corrected, within 30 days, the penalty is $15 per return. If the correction is made after 30 days but no later than August 1, the penalty is $30 per return. If filed or corrected after August 1, the penalty is $50 per return.

Clearly, the quicker you correct the problem, the lower the penalty. And, probably the better your chances of getting the penalty waived.

Waivers. While getting a waiver is far from automatic, many taxpayers stand a good chance. You have to show that the failure was due to reasonable cause and not willful neglect. To show reasonable cause you must establish that either:

1. There are significant mitigating factors with respect to the failure; or
   
2. The failure arose from events beyond your control.

In addition, you must establish that you acted in a reasonable manner, both before and after the failure occurred.

What are significant mitigating factors? Mitigating factors include, but are not limited to:

1. The fact that prior to the failure you were never required to file the particular type of return or furnish the particular type of statement, or
   
2. That you have an established history of complying with the information reporting requirement for the type of return where the failure occurred.

How can you show you have a history of complying? You should be able to show that you have incurred no penalty for failing to file for several years, or if you have incurred a penalty, that you can show that you've made progress in reducing your error rate from year to year.

What are events beyond your control? Events which are generally considered beyond your control include, but are not limited to:

• The unavailability of the relevant business records, which must be due to an event such as a fire or other casualty that damages or impairs your system for processing records or the unavoidable absence (e.g., due to death or serious illness) of the person with the sole responsibility for filing the return. There can be other reasons.
  
• An undue economic hardship relating to filing on magnetic media.
  
• Reliance on bad advice from the IRS (caution, you've got to meet several requirements here).
  
• Certain actions of an agent.
  
• Certain actions of the payee or any other person providing necessary information with respect to the return.

The last two items need some explanation. In order to establish reasonable cause due to the actions of an agent, you must show you exercised reasonable business judgment in contracting with the agent to file timely, correct information returns or furnish timely correct payee statements (1099s, K-1s, etc. given to the payee). This includes contracting with the agent and providing the proper information sufficiently in advance of the due date of the return or statement to permit timely filing, and that a significant mitigating factor prevented the agent from timely filing or that the agent had reasonable cause for the failure.

In the case of the last item, you must show that the payee, or another person (such as a broker) required to provide you with information failed to do so, or that the payee provided incorrect information and you relied on that information.

Responsible manner. You must also show that you acted in a responsible manner. That means that you acted as a prudent businessman in determining your filing obligations, and in handling account information and that you took significant steps to avoid or mitigate the failure, including requesting appropriate extensions of time to file, acting to remove an impediment or the cause of failure once it occurred, and rectifying the failure as promptly as possible.

In practice. Probably the easiest exceptions to meet are that you relied on an agent (e.g., your CPA), you can show this is the first time you had to file this type of return, or you've got a good track record in filing in the past.

Incorrect information. There's a special exception for returns that are timely filed, but contain incorrect or missing information that is corrected on or before August 1. It's called a de minimis exception and it's limited to the greater of 10 returns or 1/2 of 1% of the total number of information returns required to be filed for the year. And there's no penalty if the missing or incorrect information doesn't hinder the IRS from processing the return.

TIN. Special rules apply to getting a payee's taxpayer identification number. We won't go into that here. However, the idea is the same as above. If you don't have the correct TIN, but have made a reasonable effort to get it, you may be able to get any penalty abated. You may be able to avoid a penalty if you ask for the TIN when you first do business with the payee. Give the payee a W-9 and ask him to complete it. If you really want to be safe, refuse to pay the individual until you receive his TIN.

What about other returns? Whether or not you can get a waiver depends on the penalty. And different penalties require different approaches. Here are some starting points:

• you can show a good history of filing on time, and this was an aberration,
  
• you can show you relied on a professional such as a CPA or attorney,
  
• there were factors beyond your control such as a fire, theft, etc. and you tried to reconstruct your records as quickly as possible, and
  
• the delay was as a result of a disaster in a presidentially declared disaster area.

Net Operating Losses

Most taxpayers have heard of net operating losses (NOLs). But most people associate them only with corporations. Under current law a corporation can carry back a net operating loss two years. Any unused losses can be carried forward 20 years.

But individuals are also entitled to carry back (2 years) and forward (20 years) a net operating loss. The calculations are somewhat more complicated, but the general theory is the same. The greater complexity is due to the fact that an individual can only use the following kinds of losses to generate the NOL:

• From a trade or business.
  
• From your work as an employee.
  
• From a casualty or theft.

While partnerships, S corporations, and LLCs cannot use an NOL (all the income and deductions are passed through to the shareholders or partners), the partners or shareholders can use their share of the business losses to take an NOL on their personal return.

Example--Fred Flood is a 50% shareholder in an S corporation. In 1999 his share of the loss is $75,000. For the year Fred has $25,000 in wages and $1,000 in interest income. Fred has an NOL which he can carry back to 1997 to offset income in that year.

Computing the NOL can be tedious (many tax preparation programs will do it automatically), but before you spend the time to go through the details, there's a quick check you can make. Go to the line labeled Taxable Income (on the back page of Form 1040; on 1998 returns it's line 39). If the amount is negative, you may have an NOL. If the amount is zero or more, don't bother continuing; you don't have an NOL.

How to Compute an NOL

Even if your taxable income is negative, that doesn't mean you have an NOL. You've got to add back certain items. They include:

• Personal exemptions.
  
• Capital losses in excess of capital gains.
  
• Nonbusiness deductions in excess of nonbusiness income.
  
• Net operating loss deduction.
  
• The Sec. 1202 exclusion of 50% of the gain from the sale or exchange of qualified small business stock.

We won't explain the last one because it'll only occur if you sell stock in a closely held C corporation, and then only if you meet a number of tests.

The first adjustment item is straightforward. You've got to add back your personal exemptions to your taxable income.

The second item is only slightly more complicated. You can deduct your nonbusiness capital losses only up to the amount of your nonbusiness capital gains. Or, put another way, you can't deduct a net nonbusiness capital loss. For example, you had investment gains of $3,500 and investment losses of $4,700 on your Schedule D. You're allowed to use up to $3,000 of net capital losses to offset ordinary income. When computing your taxable income you'd be able to deduct a net capital loss of $1,200. However, when computing your NOL, that's not allowed, so you must add that amount back.

If you have business capital losses, you can deduct those only up to the total of your nonbusiness capital gains that are more than the total of your nonbusiness capital losses and excess nonbusiness deductions and your business capital gains. Fortunately, most taxpayers will only have to deal with nonbusiness capital losses.

The third item is the one you're most likely to encounter. You can only deduct your nonbusiness deductions up to the total of:

• your nonbusiness income, and
  
• your nonbusiness capital gains that are more than your nonbusiness capital losses.

In this discussion, we'll keep it simple and deal only with the first issue. But first, you've got to know what nonbusiness income and deductions are.

Nonbusiness deductions are those that are not related to your trade or business or employment. For example, deductions for alimony, contributions to an IRA, medical expenses, charitable contributions, etc. are nonbusiness deductions. Business deductions include expenses incurred in carrying on your trade or business or your employment, your share of business losses from a partnership, LLC, or S corporation and:

• Casualty and theft losses.
  
• One-half of the self-employment tax.
  
• Moving expenses.
  
• State income tax on business profits.
  
• Loss on property you rent out.
  
• Loss on the sale of business real estate or depreciable business property.
  
• Loss on the sale of accounts receivable (if you use the accrual method of accounting).
  
• Unrecovered investment in a pension or annuity claimed on a decedent's final return.

Nonbusiness income is any income not related to your trade or business or your employment. That includes interest, dividend, and annuity income. You may also have some nonbusiness income flowing through from a partnership, LLC or S corporation.

Business income includes salaries and wages, self-employment income, and your share of business income from a partnership or S corporation. It also includes rental income or ordinary gain from the sale or other disposition of business real estate or depreciable property.

Comprehensive Example

The easiest way to understand the mechanics of computing an NOL is to go through an example. The facts below are representative of what you're likely to encounter in a real situation. However, we've avoided dealing with some of the complexities, including what happens in the case of a capital loss.

Example--Fred Flood is a 50% owner in Madison, LLC. His share of Madison's loss is $75,000 for the year. In addition, Fred files a joint return with his wife, Sue. They have the following items on their tax return:

	Sue's salary                                      $12,000
	Interest income                                     5,000
	Madison LLC loss                                  (75,000)
	Keogh plan contribution                            (2,000)
        Real estate tax deduction                          (2,500)
	Charitable contribution                              (500)
	Home mortgage interest				   (1,700)
	Union dues for Sue                                   (200)
        Personal exemptions                                (5,400)
             Taxable income                               (70,300)

No adjustment has to be for Sue's union dues. Since they're related to her trade or business, they're business deductions.

Thus, Fred and Sue's NOL is:

	Taxable income                                    $(70,300)
	Add: Personal exemptions                             5,400
	Add: Excess nonbusiness deductions                   1,700
             Net operating loss                            (63,200)

Form 1045

The above example will give you a good idea of how to make the required adjustments to compute your NOL. In practice you'll have to complete Schedule A of Form 1045. You may be able to just plug numbers into that form. However, understanding the example above will help it make sense.

After you've completed Schedule A to determine your NOL, you must carry back the NOL two years. For example, if the NOL occurs in 1999, you first carry it back to offset 1997 income. If your income for that year is too low to use up all the NOL, you carry it then to 1998. Any unused amount from 1998 is carried forward to be used on your 2000 (and possibly subsequent) returns.

You can file a statement to elect to forgo the carryback and just carry it forward. That makes sense if you were in a low bracket in 1997 and expect to be in a higher bracket in 2000. You must file the election with your tax return by the due (including any extensions).

If you're carrying back the loss, you've now got two choices. You can file Form 1045 (Application for Tentative Refund) or Form 1040X (Amended Return) to get a refund for the year you're carrying the loss to. You can get your refund faster using Form 1045, but you must file on or after the date you file the return for the NOL year (e.g., 1999 in our example), but no later than one year after the NOL year. Thus, you would have until December 31, 2000 to file Form 1045 for tax year 1999.

You can file 1040X any time within 3 years after the due date, including extensions, for filing the return for the year of the loss. You must attach a computation of your NOL using Schedule A of From 1045, and, if it applies, your NOL carryover using Schedule B of Form 1045.

Carrying back the net operating income loss will reduce your adjusted gross income in the year of the carry back. That means you'll have to recompute phaseouts, limitations, floors, etc. For example, if your original AGI was $100,000, your medical expenses would have to exceed $7,500 (7.5% of AGI) before you could get any deduction. If the NOL reduces your AGI to, say $20,000, any medical expenses in excess of $1,500 would be deductible. In general, these recomputations should result in more tax benefits--but not always. For example, your charitable contributions could be limited. You might also be able to take some credits you might not have been entitled to originally. This is one time when professional help or the use of tax software will definitely prove worthwhile.

Summary

This article won't make you an expert on NOLs. However, you should have an idea of how the calculation is done and realize that if your business has a loss, there's a chance you might be able to carry the loss back for a refund for earlier years' taxes. The next step is to get Form 1045 and work through Schedule A.

Things can quickly become complicated. For example, special rules apply if there's a change in your marital or filing status for any of the years at issue. And, you may also have to compute an alternative minimum tax net operating loss. That could be different than your regular tax NOL.

You should consider getting professional help or using commercial tax preparation software. More than likely the tax savings from an NOL are substantial. Doing it right is worth the effort.

A final point. The larger your NOL, the bigger the likelihood of an audit. The IRS may still be gun-shy from earlier days when tax shelters created losses that were carried back to get refunds.

Make sure you keep good records. In a recent Tax Court case (Gerald Q. Ashbrook, T.C. Memo. 1999-300) the Court disallowed an NOL carryforward because the taxpayer could not prove he incurred a net operating loss in the earlier years.

Travel and Entertainment Tax Traps--Part I

IRS agents almost always look at T&E expenses of small businesses. They know that there's a high probability they can pick up some nondeductible expenses. Even if the owners aren't trying to get away with something, the rules are complex enough that they're sure to slip up on something. Here are some traps that you should avoid.

Spouse on trip. Years ago all you had to do to deduct the traveling expenses of a spouse, dependent, or other individual on a business trip was to show that his or her presence was helpful to your business. That won't work any more. Now, in order to deduct travel expenses for your spouse, etc. you've got to show that the individual:

• was an employee of the company paying or reimbursing the expenses,
  
• the travel of the spouse, etc. is for a bona fide business purpose, and
  
• such expenses would otherwise be deductible.

Basically, that means if you want to take your spouse on a business trip and deduct his or her share of the expenses, he or she has to be on the payroll. That doesn't necessarily mean they have to be a full-time employee. However, you can't put your spouse on the payroll for 3 days a year and expect not to be challenged. He or she should perform regular work, say 10 to 15 hours per week.

What if your spouse isn't on the payroll? You can't deduct his or her travel expenses such as plane fare, meals, etc. and your lodging deduction must be based on single occupancy room. However, if your spouse accompanies you on an entertainment outing with another couple while on the trip, the entertainment should be deductible subject to the normal rules.

Skyboxes. Your deduction for a skybox rental or similar private luxury seat may be limited to the cost of a nonluxury seat for each person entertained. And, of course, any deduction is further limited by the 50% rule.

The limit only applies if the skybox is rented for more than one event. Two or more related leases are treated as one lease. For example, at the beginning of the season you rent a skybox for one game for a group of customers. Just before the playoffs you rent the skybox for another game with the same customers. The events are unrelated, so you're not limited by this rule. You don't rent a skybox or similar luxury seating at any other time during the season. You may deduct the full cost of the skybox rental (subject to the 50% rule for entertainment).

Now assume you're offered a special deal. You rent the skybox for 3 consecutive home games. Your deduction for the rental is limited to what it would cost for the same number of people for regular box seats.

Tickets. You can only deduct the face value of the ticket plus any applicable tax (prior to the application of the 50% rule). The same rule applies to tickets purchased through a ticket agency. Only the face amount is deductible. The rule applies to all tickets to entertainment events. That means theater tickets as well as tickets to sporting events.

There's a special exception to this rule for tickets to charitable events. Amounts over the face value are deductible if the main purpose of the event is to benefit a qualified charitable organization; the entire net proceeds go to the charity; and the event uses volunteers to perform substantially all the event's work.

Club dues and entertainment facilities. No deduction is allowed for most club dues (there's an exception for chamber of commerce, public service organizations, boards of trade, etc.) Club dues disallowed include country clubs, social or athletic, luncheon, sporting, airline clubs, etc.

However, if you take a customer or client to a club for lunch or some other form of entertainment, the lunch is deductible (subject to the 50% rule).

The same rules apply to entertainment facilities such as a yacht, hunting lodge, etc. No deduction for the facilities, but you may be able to deduct meals and entertainment expenses while there if you meet the regular requirements.

Business gifts. They're limited to $25 per donee. That's it. If the gift is more costly, the excess is not deductible. There's an exception for identical items costing no more than $4 that has your name permanently imprinted on it. For example, you give one of your clients 20 $3 pens.

You can't get around the restriction by giving a larger gift to the corporation. That's considered intended for the personal use of an officer or employee of the corporation. Nor can you circumvent the rule by giving the gift to a spouse of the intended donee. Nor can a husband and wife who work for the same business piggyback gifts to one client. For the gift rules, a husband and wife, whether the donor or donee, are considered a single taxpayer.

If you want to do something special, the best approach is to take the donee out to dinner or some form of entertainment.

Next issue. In the next issue we'll discuss conventions and when your deductions are limited or not allowed, the basics of insuring your foreign travel expenses are deductible, and other traps.

Partnerships and LLCs--Computing Your Basis

While computing your basis in a partnership or LLC may sound like an esoteric subject, it's vitally important. Your basis will determine whether a distribution to you is taxable or nontaxable, or losses incurred by the business are deductible or nondeductible on your personal return. It will also determine your gain or loss if you sell all or a portion of your interest in the partnership or LLC. Unfortunately, while the theory is similar, the rules for computing basis are more complex for partnerships and LLCs than they are for S corporations.

Here's a quick example of what type of problem you can encounter.

Example--Fred Flood owns a 50% interest in Madison LLC. His basis in the LLC at the beginning of 1999 is $5,000. Sue Sharp is the other 50% owner. Her basis at the beginning of the year is $100,000. During the year Madison has losses of $40,000 ($20,000 for each partner) and distributes $30,000 to each partner. The result? Sue's starting basis is so high she doesn't have a problem. The distribution isn't taxable to her and she can deduct her share of the $40,000 loss. Fred's not so lucky. He can only deduct $5,000 of the his $20,000 share of the loss. The remaining $15,000 can be carried forward. But he's got a bigger problem. The loss reduces his basis to $0. That means the $30,000 distribution is taxable income to him.

General Rules

Basically, like a shareholder in an S corporation, a partner or member in a partnership or LLC increases his basis for additional capital contributions or loans made to the business and for the net income generated by the business. You decrease your basis for distributions and business losses.

You also increase your basis for separately stated income items. For example, interest income of the partnership isn't included in the partnership's income, but reported to the partners separately and includible on their individual tax returns. That interest income increases basis. Likewise, separately stated items of deduction or loss reduce basis. The Section 179 expense election for equipment is reported separately on the partners' Forms 1040, but it reduces their basis. There are a number of other items that are separately stated. We've included them on the form below.

But partnerships have some additional twists. You can increase your basis for your share of the partnership's liabilities for which you are responsible. For example, the partnership has accounts payable and a bank loan totaling $100,000. You and your partner each have a 50% interest in the partnership and have guaranteed the bank loan. The liabilities would increase your basis by $50,000.

Generally, liabilities are allocated to the partners based on the partners' profit-sharing ratios. In order to be able to include the liability in your basis, you must be deemed to bear the economic risk of loss. If you guarantee the loan, you're considered to bear the risk of loss. That's true whether the loan is recourse or nonrecourse. Things can get pretty complicated here. To determine if you bear the risk of loss for a recourse loan, you have to use a "constructive liquidation" approach. That's beyond the scope of this article. Suffice it to say, you just can't take the liabilities total on your balance sheet and add it to your other items making up your basis.

There's a big trap here. Just as an increase in liabilities can increase your basis in a partnership or LLC, a decrease in liabilities will reduce your basis. Thus, if you have a net reduction in liabilities as a result of paying off accounts payable, making principal payments on bank loans, etc. your basis will decrease. That basis reduction could result in a distribution to you being taxable or loss passthroughs not deductible. If your equity investment is small and your basis low, you should compute your basis regularly, or at least before the partnership makes distributions and certainly before the end of the tax year.

Fine Points

Change in partnership structure. Just as your basis can change because of an increase or decrease in the total liabilities of the partnership, it can change because of a change in the number of partners in the partnership. For example, Madison Inc. has $90,000 in liabilities. Fred, Sue and Mike are equal partners, so each can count $30,000 of the liabilities in their basis. Mike pulls out of the partnership, leaving Fred and Sue to share the $90,000 liability. They will each increase their basis by $15,000, the difference between $30,000 and $45,000.

Zero basis and tax benefits. The law prohibits a partner's basis from being reduced below zero. Any required reductions will only bring the basis to zero. But a partner must reduce his basis, even if he gets no tax benefit. For example, Fred's share of a Sec. 179 expense election is $9,500, and his basis in the partnership before the 179 election is $10,000. Fred can't use the 179 election on his personal return because he's reached the annual limit (he's got an interest in another partnership). Even though he can't claim a deduction for the $9,500, it reduces his basis in the partnership.

Contributing property subject to a liability. Any property you contribute to the partnership will increase your basis in the partnership by the amount of your basis in the property. But if the partnership assumes a liability associated with the property, that increase in basis is correspondingly reduced.

Example--You contribute land with a basis of $100,000 that's subject to a mortgage of $90,000. After the contribution you have a 50% interest in the partnership and the mortgage. Your basis in the partnership is increased by the $100,000 basis in the property, but it's decreased by $45,000, the portion of the mortgage for which your partner is now responsible.

Distributions and loss passthroughs. We'll cover these items in depth in our next issue. For now, you should be aware that any distributions will reduce your basis.

Partnership and LLC Basis Worksheet

We've included a worksheet that you can use to compute your basis. It may look a little intimidating at first, but if you take the time to examine it, many of the items apply only in unusual situations. You may need some help from your accountant or tax advisor. But doing at least some of the work yourself will save you money.

Basis at start of year                                       _________
Excess deductions/losses from prior years                    _________
   Net                                                       _________


Plus--Increases:

Basis from acquisition of interest during year               _________
Increase in partner's share of liabilities                   _________
Money contributed                                            _________
Basis of property contributed                                _________
Partner's gain under Sec. 721(b)                             _________

Ordinary business income                                     _________
Net income from rental activities                            _________
Interest income                                              _________
Dividend income                                              _________
Royalty income                                               _________
Net short-term capital gain                                  _________
Net long-term capital gain                                   _________
Net gain under Section 1231                                  _________
Tax-exempt interest income                                   _________
Other income                                                 _________
Section 179 recapture on disposition of assets               _________
Depletion (but not oil and gas) in excess of basis           _________
Life insurance proceeds                                      _________
Other increases                                              _________




Less--Decreases:

Portion of basis sold or transferred                         _________
Decrease in share of liabilities                             _________
Money distributed                                            _________
Property distributed (basis to partner)                      _________

Ordinary loss                                                _________
50% of meals and entertainment (1)                           _________
Section 179 expense deduction                                _________
Charitable contributions                                     _________
Deductions related to interest, dividends, etc.              _________
Interest expense on investment debt                          _________
Other nondeductible expenses (2)                             _________
Net loss from rental activities                              _________
Net short-term capital loss                                  _________
Net long-term capital loss                                   _________
Net loss under Section 1231                                  _________
Foreign taxes                                                _________
Oil and gas depletion                                        _________
Other decreases                                              _________


     Basis                                                   _________

Basis is computed separately for each partner.

(1) The 50% of meals and entertainment expenses that are not deductible still reduce your basis.
(2) Other nondeductible expenses can include fines and penalties.
(3) Distributions can include actual cash or property payments to partners or the payment of a partner's personal expenses.

In Brief:

Previously Reported In Daily Update

Adjustable rate mortgages in style again . . . Mortgage rates have risen over a percentage point in the last six months or so. Recently, they've been even higher. While that's still well below highs of just a few years ago, the interest in adjustable mortgages has increased significantly in the last few months. Right now a 1-year adjustable mortgage is about 1.5 percentage points less than a 30-year fixed loan. There are a lot of variables to check out here. Do your homework before committing, but there may be less risk with an adjustable today than in the past. While interest rates may rise somewhat, they're unlikely to increase anywhere near the levels that caused problems for homeowners who used adjustables years ago.

Hold onto that customer . . . It doesn't take an MBA in marketing to realize that it costs a lot more to find and make a sale to a new customer than to make a sale to an existing one. But how much more? Of course it depends on your particular business. Trying to sell a big ticket item that requires a lot of handholding or a service to a new customer is much more difficult than trying to sell a commodity type item where loyalty is seldom an important factor (e.g., fuel oil or gasoline). While it's tough to quantify just how much more it can cost to sell that new prospect, some researchers have estimated as much as 10 times the amount it costs to sell an existing customer. The message is clear. You'll increase your profit margins if you spend a little extra time to keep existing customers happy.

Student loans don't go away . . . Your credit card company may eventually give up on a debt; so may your bank if it feels it can't collect or can't do so at reasonable cost. But your student loan may follow you forever. Years ago it was easier to drop out and maybe avoid paying. That's no longer true. The government is chasing debtors with more fervor than ever. And the IRS can withhold any tax refund you're due. Add to that the fact that the federal and state governments share data much more freely than in the past. This is one area of government where computers are making a difference. Best advice? Don't think about not paying. If you can't pay, you should be able to cut a deal to make monthly payments to at least bring down the balance.

Company sports team . . . Sounds like a good morale builder. Your company's team in league play. You even let them play in the vacant lot next to the plant. Or just a friendly game at the company picnic. But then an employee gets hurt and sues the company. You could be liable. In one case an employee even managed to collect worker's compensation. Before jumping in on any sports or outside activities, check with your attorney and insurance agent. You don't want to be liable and not covered by insurance.

Embezzlement can begin at home . . . You always worry about that new employee who looks like he's on drugs, and maybe you should. But don't think a relative won't steal from your business. In one case three brothers were in a partnership together. The wife of one brother wasn't making the payroll tax deposits. When the husband discovered (quite by accident) a notice from the IRS, he confronted his wife. At first they tried to settle the issue and pay up. But after only a couple of weeks, the wife ran off with one of the other brothers. Seems it was planned all along. In another case a brother of the owner was asked by the outside accountant to reconcile some of the owner's personal bank accounts. He kept putting off the accountant. Finally, (again by accident) the bank called to verify an extra AMT card for the business owner. Seems the brother was diverting company money to the owner's personal account and siphoning off amounts from that account. The brother couldn't get the money directly out of the business because the outside accountant was deligently reconciling accounts and setting up a strong accounting system.

Need a shredder? . . . You may think that shredding documents before throwing them in the trash is only for the CIA and some high-tech firms. Not at all. Financial statements, customer lists, workpapers, engineering drawings, test results, plans for that IPO etc. are all valuable to a competitor or anyone wanting to know more about your company. Even if your competitor is honest, not all his employees may be. You'd be surprised how much someone can learn from even the odd bit of information.

Personal responsibilty for sales tax . . . Most states hold officers or business owners personally responsible for paying over sales tax collections. The idea is similar to that for federal and state withheld taxes. Unlike income taxes, your business is simply collecting the taxes for the state. The taxes never belonged to you. Most states will aggressively pursue officers, shareholders, or other responsible persons for those taxes. In a recent New York state ruling, a corporate officer who moved to another company location over 1,000 miles away was held responsible for the payment of sales taxes.

Casualty loss deduction depends on basis and fair market value. . . If you have a theft or casualty loss, the amount of the loss is the lesser of the reduction in the fair market value but not more than your cost. For example, you paid $2,000 for a computer but the fair market value at the time it's stolen is only $500. You can only deduct $500 on your tax return. (On your personal tax return the loss must exceed 10% of your adjusted gross income and $100.) Conversely, if a painting worth $20,000 is stolen and you paid only $12,000 for it, your deduction is limited to $12,000. That was the situation in a recent case (Donald John Vitale; T.C. Memo. 1999-272). A sculpture was stolen from the taxpayer's home. The sculpture was given to the taxpayer by his father who inherited the sculpture from his father. Since the taxpayer received the artwork as a gift, his basis was equal to his father's basis. And his father's basis was equal to the fair market value at the time of death of the grandfather. The taxpayer had two problems. First, because his father's basis in the sculpture was low, so was his basis. That severely limited his deduction. Second, since there was no record of the value at the death of the grandfather, the taxpayer had difficulty proving any basis in the sculpture. The Court determined a value using sales of similar statutes. If you have artwork, antiques, etc., particularly items you received as a gift or bequest, get and keep good documentation. Your basis will be important for casualty losses, computing capital gains, etc. Keeping copies of estate tax returns and gift tax returns makes considerable sense. And, if you're not getting an adequate tax deduction for the loss, make sure you're fully insured.

Sell mutual funds to buy individual stocks? . . . Investing in individual stocks can provide advantages over buying a mutual fund. For one thing, you're in control. You won't have to worry about any capital gains until you sell the stock. Fees may be lower too. Finally, if you're good, you may do better than the professionals. But, give it some thought first. If you sell the funds and you have a gain, you'll owe tax. When you pay the tax it'll reduce the amount of funds you'll have available to invest. That means you'll have to do better than the fund did to just break even. And, while you may do better than the professionals, you could do worse. What makes more sense? If you want to go it alone, put any new money and any distributions from your funds in individual stocks, but avoid selling out your position in the fund unless it's doing poorly.