News On The Tax Front--The latest tax news.
In Brief:--Tax, business, and personal finance tips.
Previously Reported In Daily Update
Alimony payments you make are deductible; other payments to an ex-spouse are not. One of the requirements of a payment to qualify as alimony is that the payments cease on the death of the ex-spouse. In Taylor W. Fithian III and Margarita Fithian (2002-2 USTC 50,629; U.S. Court of Appeals, 9th Circuit) the Court found that the "cease on death" requirement was met for two of the three types of payments. However, the divorce decree did not specifically provide that certain bonus payments were to cease on the death of the ex-wife. Thus, the payments were not deductible as alimony.
You may be able to escape the negligence penalty if you can show you relied on a professional (such as your tax preparer) in the preparation of your return. However, if the IRS can establish that you should have uncovered the error by reviewing your return before filing, you can't use the reliance on a professional excuse to get you out of the penalty. In Terri L. Steffen (T.C. Memo. 2002-229) the Court found that the taxpayer's husband had already been convicted of conspiring to defraud the IRS. The couple had filed a joint return. Thus, in addition to a joint liability for the taxes, the spouse was also liable for any associated penalties.
In Stephen M. Robison (2002-2 USTC 50,624; U.S. District Court, Dist. Nev.) the taxpayer filed a Form W-4 claiming to be exempt from withholding of federal income tax. The IRS informed the taxpayer that his exempt status was disallowed and that a civil penalty for false information with regard to withholding would be assessed unless he could provide a reasonable basis for the exemption within 15 days. The taxpayer did not raise permitted issues during a Collection Due Process hearing. The taxpayer's request of the Court to set aside the CDP hearing determination was dismissed because he failed to state a claim on which the Court could grant relief.
In Brandon Christopher Merriweather (T.C. Memo. 2002-226) the Tax Court sided with the IRS, allowing it to go ahead with collection despite the fact that the Service conceded the taxpayer hadn't received the deficiency notice. The taxpayer did request a collection due process hearing when he received a hearing and levy notice. The Court sided with the IRS in finding that the taxpayer was not entitled to a dependency exemption for the child he claimed as his daughter.
In Roy Eliason and Margaret Eliason (T.C. Memo. 2002-227) the taxpayers requested a collection due process hearing after receiving a hearing and levy notice. The IRS determined their income, after allowing for expenses, to be $912. The Service proposed they make monthly payments of that amount. The taxpayers rejected the offer. The taxpayers claimed the IRS abused its discretion by not taking into account additional medical expenses. The Court sided with the IRS, finding the amount was reasonable based on the taxpayers' circumstances.
Who gets the dependency exemption can be an issue in a divorce. The custodial parent can relinquish the exemption to the noncustodial parent by signing Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents. In Joann Bramante (T.C. Memo. 2002-228) the taxpayer claimed two children as dependents despite the fact that she had signed a form allowing her ex-husband to claim the children. The Court sided with the IRS, denied the exemption.
The House Ways and Means Committee has cleared two tax bills. The first would increase the capital loss limitation from $3,000 to $8,250. The second would make a liberalize the rules for IRS contributions and required distributions, increase the amount of elective deferrals under SIMPLE plans and increase the amount of catch-up contributions.
If you haven't noticed from our news section, the IRS is playing hard ball with respect to tax shelters. The emphasis to date has been on shelters used by corporate taxpayers, but it's quickly working it's quickly working down to individuals. One shelter now being pursued involves a partnership with multiple layers; the other involves an S corporation.
The IRS has issued proposed regulations (REG-124667-02) that would consolidate the content requirements applicable to explanations of qualified joint and survivor annuities and qualified preretirement survivor annuities payable under certain retirement plans, and would specify requirements for disclosing the relative value of optional forms of benefit that are payable from certain retirement plans in lieu of a qualified joint and survivor annuity. These regulations would affect retirement plan sponsors and administrators, and participants in and beneficiaries of retirement plans.
A report by the Treasury's Inspector General for Tax Administration (TIGTA) has reported that more than 600,000 families were identified as potentially eligible for the child credits but did not fully claim them. The IRS will shortly send out a packet to taxpayers that will include a letter of explanation along with tax forms and instructions on how to claim the credit if they are eligible.
Revenue procedure (Rev. Proc. 2002-62; IRB 2002-40) explains how taxpayers may make an election under Sec. 1397B of the Code to defer recognition of certain gain on the sale of a qualified empowerment zone asset (QEZ asset). If the taxpayer makes the election under Sec. 1397B as provided in this revenue procedure, gain from that sale is recognized only to the extent that the amount realized on the sale exceeds (1) the cost of any QEZ asset purchased by the taxpayer in the same zone as the sold QEZ asset during the 60-day period beginning on the date of the sale of the QEZ asset, reduced by (2) any portion of the cost of any replacement QEZ asset referred to this revenue procedure that was previously taken into account under Sec. 1397B.
The U.S. and the Isle of Man have signed an information exchange agreement that provides for the exchange of information on tax matters. The Isle of Man has been used as a haven for money laundering and tax evasion.
The Internal Revenue Service has released Revenue Ruling 2002-62 (IRB 2002-42) that will help taxpayers reduce distributions from their retirement savings accounts when there is an unexpected drop in the value of their accounts. Some taxpayers began receiving fixed payments from their IRA or retirement plan based on the value of their account at the time they started receiving payments. Those taxpayers may now switch--without penalty--to a method of determining the amount of their payments based on the value of their account as it changes from year to year. This change affects taxpayers who used one of the two safe-harbor methods described in Notice 89-25. These methods require the taxpayer to determine distributions based on the value in the IRA at the time distributions began. Revenue Ruling 2002-62 provides relief to taxpayers who selected one of these two methods by permitting them to change from a method for determining the payments under which the amount is fixed to the third method under the safe-harbor where the amount changes from year to year based on the value in the account from which the distributions are being made. In addition to permitting a one-time switch in method, the revenue ruling:
The IRS announced (IR-2002-105) that taxpayers involved in three types of tax shelters will have limited times to accept IRS offers to resolve their tax issues. After the settlement periods end, the IRS will pursue the remaining cases through its usual enforcement processes, including litigation when appropriate. The IRS identified two of the shelters--known as the Section 302/318 basis shifting and the Section 351 contingent liability--as tax avoidance transactions in notices issued last year. The IRS has not previously offered any settlements related to these transactions. Taxpayers in the basis shifting transaction will have until Dec. 3, 2002, to notify the IRS of their decision to participate in this settlement initiative. Those in the contingent liability transaction will have until Jan. 2, 2003, to apply for resolution of their tax liability under one of two settlement processes. (For more details see Rev. Proc. 2002-67; IRB 2002-43) The third type, corporate-owned life insurance (COLI), has been found to be abusive by the courts. The IRS has offered COLI taxpayers a settlement in which they retain 20 percent of the claimed benefits. This offer is being discontinued. Taxpayers will receive letters giving them 45 days to accept the offer before it ends. Taxpayers who want to use this offer but who do not receive a letter by Oct. 19 should contact the IRS by Nov. 18, 2002.
Can you claim your Fifth Amendment privilege against self-incrimination in a tax case? In Timothy Lee Nipper, et al. (2002-2 USTC 50,617; U.S. District Court, No. Dist. Okla.) the District Court sided with the taxpayer. It noted that to validly assert a Fifth Amendment privilege, the taxpayer must demonstrate that he is confronted with a substantial and real, and not merely a trifling, remote or imaginary risk of incrimination. The IRS argued that the taxpayer must disclose that he actually committed the crime before he can validly assert his rights under the Fifth Amendment. The Court did not agree.
The IRS has announced that an updated Publication 555, Community Property, is now available from the Service. This publication provides basic federal tax information for married taxpayers who are domiciled in a community property state. (Announcement 2002-85; IRB 2002-39)
You might be able to avoid delivering your books and records to the IRS in response to a summons, but you'll have to go to court. That's what the taxpayer did in Ronald I. Pointer, et al. (2002-2 USTC 50,618; U.S. District Court, No. Dist. Tex. Dallas Div.). However, he didn't succeed. The IRS showed that the investigation was conducted for a legitimate purpose, the information sought was not already in the possession of the IRS, and the proper administrative procedures had been followed. The Court held that the summonses were valid and should be enforced.
There isn't much time left for Congress to act on the tax bills still in the House and Senate. The consensus is that military tax breaks stand the best chance for passage, followed by charitable tax incentives and the energy tax incentives bill. However, many professionals wouldn't be shocked if not tax bill passes. Any pension reform bill appears dead until next year.
In Notice 2002-67 (IRB 2002-42) the IRS provided guidance with respect to the federal tax treatment of payments from the Department of Agriculture to peanut quota holders. Recent agricultural legislation repealed the marketing quota program for peanuts and directs the Department of Agriculture to make payments to peanut quota holders for the lost value of the quota resulting from the repeal. Peanut quota holders who held a quota for investment purposes generally should treat any gain as a capital gain and any loss as a capital loss. Peanut quota holders who used a quota in the trade or business of farming and held the quota for more than one year generally may be able to treat any gain as a capital gain and any loss as an ordinary loss.
The IRS has changed some of the addresses on their web site. We've started updating our links, but please be patient.
Generally, you can only deduct passive losses up to the amount of any passive income. Special rules apply to passive losses from real estate. One exception allows you to deduct up to $25,000 of such losses if you actively participate in the management of the property. Another, more important exception, applies to real estate professionals. If that's your situation, there is no limitation on the losses you can deduct from real estate activities. In order to qualify more than half of the personal service you perform during the year must be in real estate activities in which you materially participate and the time spent in those activities must be more than 750 hours. In William C. and Cheryl M. Fowler (T.C. Memo. 2002-223) the taxpayer, who performed heating and air conditioning services did not show that he spent more than the required 750 hours.
Interest on business debts is deductible, generally without restriction. Personal interest generally isn't deductible, but there are a few exceptions. Taxpayers have argued, and the Tax Court has generally agreed, that interest on a tax deficiency that arises from Schedule C adjustments should be deductible since it's business related. In Edward A. Robinson III and Diana R. Robinson (119 TC--, No. 4) the Court held that it would no longer follow Redlark and will no longer allow taxpayers a deduction for an allocable portion of any interest on a tax deficiency related to Schedule C income.
Failure to follow the procedural rules can be costly. In Michael J. Roberts (T.C. Memo. 2002-221) the taxpayer failed to file returns. The IRS sent a deficiency notice to his last known address. The taxpayer filed returns claiming deductions for his drywall business 2 months after the deficiency notices were mailed. The Court did not believe his claim of not having received the notices. A scheduled conference with the IRS did not take place and the taxpayer argued his income was too low to require him to file. The Court held the taxpayer since the taxpayer didn't seek redetermination in Tax Court as to the liability, he could question the tax in the current proceeding. The Court also noted the IRS isn't required to issue a 30-day letter before issuing a deficiency notice.
If you get a W-2, you're an employee. And you can't report the income and take deductions on Schedule C. (There's an exception for statutory employees such as life insurance salesmen and real estate agents.) In Kevin and Bridget Naughton (T.C. Memo. 2002-222) the taxpayer was a doctor who was classified as an employee by the municipal organization for which he worked. The Tax Court found that, based on the common law rules, he was an employee and not an independent contractor. Thus, he could not take deductions on a Schedule C.
In a prior revenue procedure the IRS provided relief to those taxpayers with a newly formed entity who were late in making a special entity classification (e.g., an LLC electing to be taxed as a corporation). In Rev. Proc. 2002-59 (IRB 2002-39) the Service announced that it will extend the time for filing a late initial entity classification election from six months to the due date for the federal tax return (excluding extensions) of the entity's desired classification for the year of the entity's formation.
The IRS has just announced (Rev. Proc. 2002-63; IRB 2002-41) an update of the optional methods for employees and self-employed individuals who pay or incur meal costs to use in computing the deductible costs of business meal and incidental expenses paid or incurred while traveling away from home. The per diem rate for travel to a high-cost locality is now $204 and $125 for travel to any other locality within the continental U.S. The M&IE (meals and incidental expenses) will be $45 for high-cost localities and $35 for others. The high-low per diem rate is an optional method. Taxpayers can use the actual per diem rate for specific localities. These rates can be found at www.policyworks.gov/perdiem. These rates take effect October 1, 2002. (The transition rule for those taxpayers using a calendar year still applies.) In addition, the revenue procedure makes a change in the expenses that are included under the incidental category. For travel away from home before January 1, 2003, the term incidental expenses includes, but is not limited to, expenses for laundry, cleaning and pressing of clothing, and fees and tips for services, such as for porters and baggage carriers. The term incidental expenses does not include taxicab fares, lodging taxes, or the costs of telegrams or telephone calls. For travel away from home after December 31, 2002, the term incidental expenses has the meaning given to it in the Federal Travel Regulations. For example, the term incidental expenses includes fees and tips given to porters, baggage carriers, bellhops, hotel maids, stewards or stewardesses and others on ships, and hotel servants in foreign countries but does not include expenses for laundry, cleaning and pressing of clothing, lodging taxes, or the costs of telegrams or telephone calls. In addition, Santa Monica, California; Baltimore, Maryland; Staten Island, New York; King of Prussia/Ft. Washington/Bala Cynwyd, Pennsylvania; Philadelphia, Pennsylvania; and Seattle, Washington has been added to the high-cost localities while Palm Beach, Florida has been removed from the list. We will update our list of high-low localities shortly.
If you have a high deductible health insurance plan you may be eligible to put pretax money in a Medical Savings Account (MSA). However, the number of MSAs allowed are limited. In Announcement 2002-90 (IRB 2002-40) the IRS announced that, because the number of MSAs hasn't exceeded the threshold amount, October 1, 2002 is not a cut-off date and 2002 is not a cut-off year for the MSA pilot project.
Previously Reported In Daily Update
Money market produces negative return . . . It's happened. Interest rates have fallen so low that in one money market fund the expense ratio for the most recent quarter actually exceed the income. If you haven't been watching the sales charges and expense ratio on your funds in the past, now's the time to change. Returns for most funds (bond funds may be the exception) are dismal. Don't add to the poor performance by overcompensating the managers. (On the other hand, if a fund has provided exceptional performance, don't switch just for a lower expense ratio.) High expense ratios on money market and index funds are particularly onerous since there's usually very little management involved.
Mortgage refinancing rules to change . . . Fannie Mae will be tightening standards on cash-out loans February 1, 2003. Cash-out loans are refinancing loans where the borrower not only refinances an existing loan but takes an additional amount for home improvements or other reasons. The changes include a higher fee on mortgages where the loan amount is between 70% and 85% of the value of the home and tighter standards for borrowers who consolidate first and second liens. While the rule changes only apply to loans sold to Fannie Mae, they're almost sure to be commonplace. Whether or not your refinancing will be more difficult or costly depends on your situation, but you might want to keep the change in mind.
October 15 deadline for IRAs . . . October 15th isn't only the deadline for filing your individual tax return if you have an extension. You also have until then to recharacterize (reverse) a 2001 conversion of a traditional IRA to a Roth IRA. If you invested in stocks, chances are the amount converted has declined in value. Undoing the conversion and reconverting at a lower market value is almost sure to make sense. To recharacterize the conversion, you must arrange with the IRA trustee to complete the transaction by October 15. Then file an amended return to recover the overpaid taxes.
IRS may be looking closer at trusts, nominees, and foreign accounts . . .The Internal Revenue Manual provides that examiners should inspect the cash receipts journal, sales journal, bank statements, and deposit slips to verify: transactions involving cash receipts of more than $10,000; consecutive or related transactions which total in excess of $10,000; and whether currency transactions in excess of $10,000 were reported on Form 8300. The manual further states that if an examiner discovers unusual or questionable transactions while following the procedures and scope of a compliance review, the examiner should prepare Form 5346, Examination Information Report. If transactions involving trusts, nominees, or foreign accounts are unusually suspicious or have been identified as tools that taxpayers use to avoid the reporting requirements of Sec. 6050I, then the Service can instruct examiners specifically to look for such transactions. However, the Service is not authorized to use Sec. 6050I compliance review as a pretext for other purposes. Therefore, the Service is not authorized to target trusts, nominees, or foreign accounts other than to determine whether such transactions are subject to Sec. 6050I information reporting. The writer of the memo recommended that the Service draft specific instructions directing examiners. The IRS also addressed the issue of Code Sec. 7602 notification when the IRS wants to contact third parties. A request for a business' books and records for the purpose of determining whether the business complied with Sec. 6050I does not in itself implicate Sec. 7602(c). Neither do questions concerning whether a particular transaction involved the exchange of cash. These questions relate solely to whether the business has or should have filed a Form 8300. However, further questions concerning a customer of the examined business may require a Sec. 7602(c) prenotification letter. For additional information see IRS Legal Memorandum ILM 200239034.
Insurance companies downgraded . . . Considering an annuity now? You should do some extra homework. The ratings services (Fitch, Moody's, Standard & Poor's, A.M. Best) have downgraded many insurance companies, particularly the ones that sell annuities. Why? The poor stock market has created return and risk problems for many of the companies. There are still some that might be safe investments, but now is not the time to use a dart board for picking them.
No income check mortgages . . . How can they do it? Simple, you'll pay a higher interest rate if you can't verify your income. How much higher depends on the lender. It may be only a quarter point if your credit rating is good; it could be a half point if your rating isn't.
IRS allows prior S corporation to reelect S status . . . If an S corporation's election has been terminated, the corporation (and any successor corporation) will not be eligible to make a new election for 5 years, unless the IRS consents. In a recent letter ruling (LR 200239007) all the stock in an S corporation was acquired by a regular (C) corporation. Since that's an ineligible shareholder, the S corporation terminated on that date. Some time later, but prior to the end of the 5-year waiting period, two individuals, unrelated to either the original shareholder or the corporation that purchased the shares, bought all the stock in the corporation. The corporation requested permission to reelect S corporation status, based on the change in ownership. The IRS granted the permission. The Service noted that the fact that more than 50 percent of the stock in the corporation was owned by persons who did not own any stock in the corporation on the date of the termination tends to establish that consent should be granted.
Who can claim the Hope Scholarship Credit? . . . In a recent IRS Legal Memorandum (ILM 200236001) the taxpayer was a student who could be claimed as a dependent on his parents' return. However, the parents reported adjusted gross income (AGI) sufficiently large that they could derive no tax benefit either from claiming the taxpayer as a dependent or from claiming an education tax credit with regard to any education-related expenditures they might have made on his behalf. The IRS held that because a dependency exemption was allowable to the parents of the taxpayer/student during the year in issue, the student's personal exemption amount is zero. The rule is that if an exemption is allowable to a taxpayer (the parents, here) no other taxpayer can claim the exemption, even if it isn't used or usable for some reason. The Hope credit and the lifetime learning credit provide for a credit for any dependent of the taxpayer to whom the taxpayer is allowed a dependency exemption. The parents didn't claim their son as a dependent on their return so the exemption was not allowed, thus making them ineligible to claim the education credits. That made the son the only person eligible to claim the credit. Moreover, the IRS ruled that the taxpayer became entitled to the credit not only for any qualified tuition and related expenses he may have paid, but also for any such amounts his parents may have paid on his behalf.
Trouble raising prices? . . . For many businesses it's not easy in the current market. In most cases a simple price increase may get a cool reception from your customers. That's why boosting sales by offering a temporary discount makes more sense than a price cut. Raising the price later can be difficult, but canceling a discount is easier. Of course, a discount that's around for too long often becomes the new de facto price. Consumers have become so used to 0% financing on autos, that could be what's necessary to sustain sales. What can you do to increase prices? Here are some tricks:
Transfer of installment note isn't an exchange . . . If you sell property on the installment basis you'll receive a note for the balance due. For tax purposes you'll recognize income from the sale as the note is paid off. There's a trap here. If you pledge the obligation as security for a loan or transfer it to a third party, the payments on the note will be considered accelerated. That is, the entire gain on the installment sale may be taxable at that time. In a recent technical advice memorandum (TAM 200105004) the IRS was asked to rule on a transaction where a parent corporation that transferred a note to a new subsidiary which than transferred it to a new partnership which then contributed the note to a new corporation which then ended up back with the partnership. The IRS held that the obligation was not exchanged nor did the taxpayer constructively receive payments on the note. Thus, the transactions did not generate any tax consequences. This is a tricky area and the consequences can be significant. Get good advice.
Copyright 2002 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