News On The Tax Front--The latest tax news.
Maximizing Depreciation Benefits--You may be able to write off that $75,000 SUV, but are the tax benefits worth it? And you may not want to take all the benefits in the year of purchase.
In Brief:--Tax, business, and personal finance tips.
Previously Reported In Daily Update
In Rev. Rul. 2003-119 (IRB 2003-47) the IRS announced the inflation adjusted dollar amounts for debt instruments under Section 1274A for 2004. The Sec. 1274A(b) amount (qualified debt instrument) is $4,381,300 and the Sec. 1274A(c)(2)(A) amount (cash method debt instrument) is $3,129,500.
The IRS has recently released a number of updated publications for use in preparing 2003 returns:
54 Tax Guide for U.S. Citizens and Resident Aliens Abroad
225 Farmer's Tax Guide
502 Medical and Dental Expenses
504 Divorced or Separated Individuals
524 Credit for the Elderly or the Disabled
529 Miscellaneous Deductions
533 Self-Employment Tax
547 Casualties, Disasters, and Thefts
575 Pension and Annuity Income
915 Social Security and Equivalent Railroad Retirement Benefits
1045 Tax Professionals Guide to 2003 Federal Tax Products
Early distributions from qualified pension plans are subject to a 10% penalty tax. The penalty does not apply to certain distributions, including those made "to an alternate payee pursuant to a qualified domestic relations order". A "domestic relations order" is defined as any judgment that relates to the provision of marital property rights to a spouse, or former spouse, of a participant and is made pursuant to a state domestic relations law. A qualified domestic relations order, or QDRO, is a specific type of domestic relations order that (1) creates an alternate payee's right to receive all or part of the benefits payable with respect to a participant under a plan, (2) clearly specifies certain facts, and (3) does not alter the amount of the benefits under the plan. The law defines the term "alternate payee" as any spouse, former spouse, child or other dependent of a participant who is recognized by a domestic relations order as having a right to receive all, or a portion of, the benefits payable under a plan with respect to such participant. In Randolph S. Simpson (T.C. Memo. 2003-294) while the taxpayer did not allege or contend that the amount was paid pursuant to a QDRO, the Court held that in any event he did not qualify for the Section 72(t)(2)(C) exception to the additional tax. Although the divorce decree is a domestic relations order, it is not a QDRO. Rather than recognizing an alternate payee with respect to petitioner's qualified plan, the decree divested his ex-spouse of any rights to such property and deemed that property to be petitioner's sole and separate property. Because no alternate payee was named in the divorce decree, the decree was not a QDRO. Moreover, the distribution of funds from petitioner's qualified plan was not made to an alternate payee as required. By contrast, the funds were disbursed by the plan administrator directly to petitioner. The Court rejected petitioner's argument that, because he used funds received in the plan distribution to pay his ex-spouse, she should be responsible for a proportionate share of the additional tax.
In Horace D'Angelo, Jr. (T.C. Memo. 2003-295) the IRS tried to disallow a portion of a bad debt deduction with respect to a settlement the taxpayer made for the forgiveness of accrued rent. The Court sided with the taxpayer. It noted that, according to the debt settlement agreement, the amount was not forgiven until after the redemption of a party's interest in two businesses. The Court noted the parties to that agreement went to great lengths to memorialize their understanding that this redemption was a condition precedent to the settlement of the debt and that the IRS did not allege the debt settlement agreement was a sham or that the terms should be disregarded by the Court.
Self-employment income received in a trade or business is subject to the self-employment tax. The law generally excludes rentals from real estate from net earnings from self-employment. However, real estate rentals are subject to the self-employment tax if the income is from an arrangement between the owner or tenant and another individual which provides that the other individual will produce agricultural or horticultural commodities on the land and that there will be material participation by the owner or tenant. In a Court of Appeals decision, M. McNamara (CA-8, 2001-1 USTC 50,188) the Court overruled the Tax Court and held that rent payments where not self-employment income if the lessor materially participates in farm production, but the lease agreement does not require the lessor to materially participate. The IRS has now announced (AOD CC-2003-003) that the Chief Counsel has recommended nonacquiescence with respect to the case.
In Notice 2003-76 (IRB 2003-49) the IRS is providing an updated list of transactions that have been determined by the IRS to be "listed transactions" for purposes of Sec. 1.6011-4(b)(2) and Sec. 301.6111-2(b)(2). This notice restates the list of "listed transactions" in Notice 2001-51, 2001-2 C.B. 190, and updates the list by adding transactions identified as "listed transactions" in notices and other guidance released subsequent to August 2, 2001. Transactions that are the same as or substantially similar to transactions listed in the notice have been determined by the Service to be tax avoidance transactions and are "listed transactions". As a result, taxpayers may need to disclose their participation in these listed transactions as prescribed, and promoters (or other persons responsible for registering tax shelter transactions) may need to register these transactions.
The IRS has announced (IR-2003-128) the launch of the first of a suite of internet-based business tools that give tax professionals and financial institutions easier access to client information. Known collectively as e-services, the suite of products provides tax professionals with new choices for working electronically with the IRS. The first three products provide a foundation for future services that will significantly enhance how the IRS does business with tax professionals and those who file selected information returns, such as banks and other financial institutions. Three e-services applications are being introduced. Before using other e-services products, tax professionals must register online to create an electronic account. The registration process is a one-time process for tax professionals to select a user name, password and personal identification number. An on-screen acknowledgment immediately confirms the registration process. For security purposes, a confirmation code is also mailed to the tax professional to complete the registration process. Professionals can now obtain a Preparer Tax Identification Number, or PTIN application, on line immediately. Future e-services include an online application for those who want to become authorized e-filers, an expansion of TIN Matching that allows bulk matching of thousands of Taxpayer Identification Numbers within 24 hours, and special incentive products for e-filers who file more than 100 electronic returns. Tax professionals can register for e-services immediately through the Tax Professional's page on IRS.gov.
Just because you don't get a Form 1099 doesn't mean you don't have to report the income. In Richard A. Brunsman (T.C. Memo. 2003-291) the taxpayer didn't report some $26,800. While the individual's employer claimed he presented the 1099 to the taxpayer, the taxpayer claimed not to have received it. The taxpayer argued he wasn't liable for the tax because he didn't receive the 1099. Alternatively, the taxpayer contended that a portion of the amount received ($4,400) represented the sale of assets to the employer. The Court was willing to assume the taxpayer sold some assets, but he failed to provide any information concerning the identity of the assets, the bases, or when they were purchased. Without that information, the Court found the entire amount was taxable income. The Court sided with the IRS and allowed the accuracy related penalty for substantial understatement of income tax. The Court said the taxpayer did not need to receive a Form 1099-MISC to be alerted to the fact that he received compensation from his employer for his services.
You may be able to have your debts discharged in bankruptcy, but paying some creditors ahead of others can jeopardize the discharge. In In re Christine Carter Lynch (2003-2 USTC 50,686; U.S. Bankruptcy Court, So. Dist. N.Y.) the Court noted the taxpayer had a luxury apartment, ate dinner in restaurants four days a week, traveled considerably to California, China and Paris, made huge gratuitous transfers to her church, all ahead of payment of her back taxes. The Court also noted that apart from the decisions by the taxpayer to allocated financial resources for the payment of obligations other than taxes, the cancellation of paycheck direct deposit shortly after learning the IRS intended to levy her bank account constituted an affirmative act to evade the payment of taxes. The Court held that the taxpayer's tax liabilities with respect to her taxes were not dischargeable in bankruptcy.
The IRS does not have to accept your offer-in-compromise. In fact, many offers are not accepted, often because the IRS believes the taxpayer can pay the amount due, either in one lump-sum or in installments. In Amy H. O'Brien (T.C. Memo. 2003-290) the taxpayer made an offer-in-compromise which was rejected by the IRS. The taxpayer argued that the rejection was an abuse of discretion, arguing that she could not afford to pay her liabilities in full. The IRS noted that the taxpayer was the beneficiary of a trust with more than sufficient assets to pay the full amount. The Service contended that the taxpayer failed to establish economic hardship or to present compelling public policy or equity considerations, as described in the applicable regulations, that would show any abuse of discretion in the Service's actions against the trust assets. The Court looked at not only the taxpayer's earnings (which were modest), but also her expenditures. The Court noted that some of the listed expenditures were for more than basic necessities (e.g., wine store, cafes, video stores, etc.). In addition, the Court noted there was no evidence of any illness, medical condition or disability that would render the taxpayer incapable of earning a living or would exhaust all of her financial resources. Both parties agreed that the assets of the trust were reachable. Under state (New York) law, the interest of a beneficiary under a spendthrift trust may be reached by the U.S. under an income tax lien. Moreover, the taxpayer could enforce her right to trust property or income. The Court sided with the IRS. It found the IRS followed the prescribed guidelines in rejecting her offer-in-compromise.
The IRS can refuse an offer-in-compromise, but it has to follow certain guidelines. In In the Matter of William K. Holmes (2003-2 USTC 50,685; U.S. Bankruptcy Court, Mid. Dist. Ga., Macon Div.) the IRS refused to process the debtor's offer-in-compromise. The Bankruptcy Court ordered the IRS to consider the debtor's offer.
In Charles R. Goodwin (T.C. Memo. 2003-289) the taxpayers requested an additional extension of time to file. Upon filing their return, the taxpayers requested additional time to pay their liability. The taxpayers requested additional time to file and pay because of casualty losses related to storms, electrical outages at their home and office, personnel changes (including that of a bookkeeper) at his office. The Court found the taxpayers did not exercise due care to set aside otherwise liquid funds to pay estimated taxes for the years at issue. The Court noted the taxpayers had substantial income during the year but invested it in property and made substantial charitable contributions rather than putting the money in liquid assets. The taxpayers did not properly file a separate request for an extension of time to pay their taxes, which must be made on Form 1127, Application for Extension of Time for Payment of Tax. Nor did they pay their tax liability when they filed their Form 4868. As a result, taxpayers' liability for the Sec. 6651(a)(2) addition to tax began to accrue on April 16, 1998. The Court held the taxpayers liable for additions to tax for late payments and the addition to tax for late filing.
The IRS can't make adjustments to your return after the statute of limitations has run. But if you're waiting for that magic moment, you've got to know when the statute starts running. The same is true if you're filing a refund claim or a similar action. In Michael J. Nardini and Mary J. Nardini (2003-2 USTC 50,677; U.S. District Court, No. Dist. N.Y.) the taxpayers signed Form 2297, Waiver of Statutory Notification of Claim Disallowance. The Court noted this form begins the 2-year period of limitation for filing suit for a refund for the claims that were listed and disallowed. Since the taxpayers failed to file a claim within the deadline, their refund claim was disallowed.
If you're using the accrual method of accounting you can generally deduct an expense you don't pay until the year following the year you incur the expense. But there are some very strict rules. In Jimmy D. Weaver and Marlene M. Morloc Weaver (121 TC--, No. 14) the taxpayer owned 80% interests in an S and a C corporation. The S corporation was on the accrual method; the C corporation on the cash method. The S corporation deducted amounts owed to the C corporation for services it rendered to the S corp. during the year. The S corporation had not paid the amounts owed by 2-1/2 months after the end of its taxable year. The Court held the S corporation failed the economic performance requirement of the law with respect to amounts for services since the amounts were not paid within 2-1/2 months of year end and disallowed the deduction.
The IRS has released Rev. Proc. 2003-77 (IRB 2003-44) updating Rev. Proc. 2002-66, and identifying circumstances under which the disclosure on a taxpayer's return with respect to an item or a position is adequate for the purpose of reducing the understatement of income tax under Sec. 6662(d) (relating to the substantial understatement aspect of the accuracy-related penalty), and for the purpose of avoiding the preparer penalty under Sec. 6694(a) (relating to understatements due to unrealistic positions).
The rule is that if you're married and filing separately, you can't claim itemized deductions if your spouse does not elect to itemize. In David J. Boyd (T.C. Memo. 2003-286) the Court sided with the IRS in not allowing the taxpayer's itemized deductions. The Court noted that itemization is only allowed when the taxpayer makes an election. The taxpayer did not elect to itemize on his original individual return. Moreover, a change of election will not be allowed unless the taxpayer's spouse elects consistent treatment and consents in writing to the assessment of any deficiency arising from the change. The taxpayer's spouse did not elect to itemize deductions on her original return, nor did she consent to itemization when the taxpayer amended his return. In addition, the taxpayer was denied deductions for car, truck, meal, travel and other expenses because he failed to substantiate the expenditures. The Court allowed a nominal amount under the Cohan rule.
When a return is filed can be of paramount importance. The filing starts the statute of limitations period. In Timothy J. McCarville (2003-2 USTC 50,669; U.S. District Court, East. Dist. Wis.) the taxpayer argued that the statute of limitations began to run when the taxpayer's employer filed forms W-2 or when the IRS filed a substitute return for the taxpayer. The Court sided with the IRS in finding that neither of these items were returns. Only when the taxpayer finally filed a return did the statute did not begin to run.
Settlements received for physical injury may be excluded from your income. In Rodell Johnson (2003-2 USTC 50,670; U.S. Court of Appeals, 10th Circuit) the taxpayer who had worked as guard at a correctional institution received front and back pay damage award under the Americans With Disabilities Act after he was terminated. The Court found the amounts taxable since there was no direct relationship between the amounts received and his physical injuries.
If you're an officer, owner, or even an employee for a company or other entity that pays wages, you can be held personally liable for any withheld but undeposited payroll taxes. In a small company an officer such as the president, treasurer, etc. that's considered liable. The IRS usually looks at who had the authority to pay the bills, write the checks, etc. In In re E. Harry Lartz, Debtor (2003-2 USTC 50,674; U.S. District Court, Mid. Dist. Pa.) the Court found that the unpaid president of a nonprofit social club was not a responsible person. According to the bylaws, the president did have financial authority. When he learned of the financial difficulties of the club and the unpaid employment taxes, he tended his resignation, but the club refused to accept it. The Court noted that the club employed several full-time staff members to manage its affairs, including a general manager, bookkeeper, and a catering manager.
Maximizing Depreciation Benefits
Introduction
We've had a number of questions regarding the new 50% bonus depreciation, the $100,000 expense option, the possibility of writing off a $60,000 SUV in the first year, etc. This article attempts to answer some of the questions and provide some guidance in using the new, more liberal depreciation and expensing rules. And, while you can get a big writeoff in the year of purchase, there are some important considerations other than taking a big tax deduction.
SUVs
Depreciation and leasing deductions for autos and light trucks are generally limited. For 2003 (the amount is indexed for inflation and generally changes every year) depreciation is limited to $3,060 in the year placed in service, $4,900 in the second year, etc. no matter how expensive the vehicle. For new vehicles that qualify for the additional 30% or 50% depreciation, the first-year depreciation deductions are higher. Deductions for lease payments are also limited. The rules don't apply to vehicles used primarily in the transport of persons or property for hire (e.g., taxicabs, delivery vans, etc.)
Any 4-wheeled vehicle with a unloaded gross vehicle weight of 6,000 pounds or more isn't subject to these restrictions. However, most cars don't break that weight limit.
For trucks, vans, and SUVs, the 6,000 pound threshold is based on the loaded gross vehicle weight (vehicle plus passengers plus cargo). Thus, many trucks, SUVs, etc. break the 6,000 pound threshold and there's no limit on the first-year depreciation, Section 179 or lease payment deductions.
For 2003 (and future years) the IRS has added a new category. Trucks and vans refers to vehicles that are built on a truck chassis, including minivans and sport utility vehicles (SUVs) that are built on a truck chassis. In order to qualify, the vehicle must be a qualified nonpersonal use vehicle. For trucks and vans, that generally means vehicles that have been specially modified, such as by installation of permanent shelving and painting the vehicle to display advertising or the company's name, so that they are not likely to be used more than a de minimis amount for personal purposes. These specially manufactured or modified vehicles do not provide significant elements of personal benefit, and a taxpayer is unlikely to purchase these vehicles unless motivated by a valid business purpose that could not be met with a less-expensive vehicle. These vehicles are still subject to depreciation and lease payment limitations, but the limits are higher.
Basic Tax Rules
You generally can't expense equipment, furniture, etc. used in your business that has a useful life of more than a year. You must capitalize and depreciate the asset over a number of years. How long depends on the asset and your type of business. Office equipment generally must be depreciated over 7 years; computers over 5; buildings over 39. There are general and alternative depreciation schedules. Most taxpayers use the general rule. For 5-year property the rates are 20% for the first year, 32% for the second, 19.2% for the third, 11.52% for the fourth and fifth year and 5.76% for the last year (5-year property is depreciated over 6 years). Thus, for a $10,000 asset, you'd take $2,000 of depreciation in the first year, $3,200 in the second, etc.
For a number of years, tax law has allowed taxpayers to expense a certain amount in the year of purchase. (The Section 179 expense option.) For example, in 2002 you could expense up to $24,000 of assets acquired in the year. That option has two benefits. First, you can get a deduction upfront. Second, for assets where you elect to expense completely, you don't have to calculate and track depreciation every year. Finally, there's no alternative minimum tax adjustment as there is with the normal depreciation rules.
Recent law changes allow taxpayers to signficantly accelerate depreciation deductions on most assets.
First, the Section 179 expense option has increased to allow up to $100,000 of personal property to be expensed in any taxable year. There are a number of limitations. The most significant for small business owners is that the deduction is limited to the income from the activity. New and used equipment qualifies, but leasehold improvements, buildings, building improvements, etc. do not. The $100,000 limit applies to 2003, 2004, and 2005. The limit reverts to $25,000 in 2006.
Second, for property acquired after September 10, 2001 and before September 11, 2004, you can take a special 30% additional depreciation deduction. For property acquired after May 5, 2003 and placed in service before January 1, 2005 a special 50% additional depreciation deduction applies in place of the 30% additional amount. The property must have a recovery period of 20 years or less. Only new (not used) property qualifies. Property that must be depreciated using the ADS system (e.g., autos used 50% or less for buiness) does not qualify. Computer software and certain leasehold improvements (but not other real property) qualify. If you qualify, the 50% additional depreciation is automatic. For any class of property you can elect to take no additional depreciation or take the 30% additional depreciation.
Example--Madison Inc. purchases a machine (7-year life) for $70,000 in 2003. Madison elects the Sec. 179 expense option on $20,000 of the cost. (It's already used $80,000 of its available $100,000 Sec. 179 expense option limit on the other property.) The $20,000 reduces the basis of the machine to $50,000. Madison uses the 50% additional depreciation deduction of $25,000 (50% of $50,000) to reduce the basis to $25,000. The regular depreciation for 2003 is $3,571 (14.2% of $25,000). The final adjusted basis is $21,429, or a total of $48,751 in depreciation for the year.Using other numbers, on equipment purchases of $200,000 (where all the equipment is in the 5-year life class) you could take $160,000 of depreciation in the first year.
Return on Investment (ROI) and Tax Benefits
Before exploring the tax considerations of a big writeoff, let's examine what the immediate writeoffs mean to you. First, the 50% additional depreciation and the $100,000 expense option aren't giving you something new. All they're doing is giving you what you'd otherwise get, but much sooner. For example, if you purchase new office furniture for $5,000 under the regular rules you'd get to depreciate the entire cost over 7 years. Your deduction in the year of purchase would be $714. Your second year deduction would be $1,225, etc. Clearly, a deduction today is worth more than one tomorrow. The time value of money (present value analysis) proves it. But that upfront deduction is worth more when interest rates are high. And immediate writeoff is more beneficial and should be used on the longest-lived equipment first.
Second, while a tax deduction saves taxes, the amount depends on your tax rate. The higher your marginal tax rate, the bigger the savings. For example, you purchase a $1,000 machine that you write off in 2003. If you're in the 40% bracket, you'll save $400 in taxes. Or, looking at it another way, Uncle Sam (and your state) is picking up $400 of the cost of the machine--you're paying for the other $600. If you're in the 15% bracket, the government is paying for only $150--you're paying for the other $850.
That brings us to return on investment or ROI. Whether buying the new computer, machine, etc. is worth it generally depends on an ROI analysis. Sometimes no analysis is necessary. If you're a carpenter and your miter saw burns out, you've got to buy a replacement. But if your truck engine seizes, you've got several options--get a new or rebuilt engine, buy a used truck, or buy a new truck. Which option is best depends on a number of factors as well as a review of the costs and revenue generated by the equipment.
The best way to determine whether a new piece of equipment or other investment is a worthwhile purchase is doing a present value or rate of return analysis. The general approach is to equate the cash outlay for the equipment with the present value of the savings or revenue generated by the equipment. If you're not familiar with these methods or the investment is very risky, there's a simpler way. It's called the payback period. It's the length of time it will take to recoup your cash outlay. Often used as a quick way to analyze an investment, usually in personal property. For example, a new machine will cost you $10,000 after subtracting the up-front tax savings. It will generate after tax income of $3,000 the first year; $4,000 the second year and $3,000 the third year. The payback period is 3 years. Compare the payback period with the projected useful life of the equipment. If it's more than the payback period, you should buy the equipment. The shorter the payback period, the more attractive and less risky the investment
Limitations
Before assuming you can deduct and get a tax benefit for the maximum Sec. 179 expense option or depreciation, you should review your tax situation. The Sec. 179 expense option is phased out if you purchase more than $400,000 of equipment eligible during the year, the amount you can expense is reduced. And, the expense deduction can't exceed the taxable income derived from the trade or business (the excess can be carried forward).
In the case of listed property (e.g., autos and many other vehicles) the business use must exceed 50% in order to be able to use the Sec. 179 expense option, the additional depreciation or any accelerated depreciation. In fact, if you don't meet the threshold, only straight-line depreciation can be used. You can change personal use to business use by either having an employee pay for the use of the vehicle or adding the value of the personal use to his or her W-2. But that approach won't work if the vehicle use is by a 5% or more owner or related individual.
State rules can vary. Some states do not allow the 30% or 50% additional depreciation or the full Sec. 179 expense option. While that shouldn't really affect your decision to purchase, you should keep this in mind when preparing your return.
When Not to Maximize Depreciation
It would appear that the quicker you get your deduction, the better off you are. That's certainly true if all you do is a present value analysis. But once you add in the complications of the tax law, it's not that simple. There are a number of factors to consider before taking the maximum writeoff.
Tax rates. We said above, your tax benefit depends on your tax rate. (In this analysis, we'll assume you're doing business as an S corporation, partnership or LLC, or sole proprietorship since that's the way most small businesses are operated. The analysis is similar for a C corporation. All the analyses assume married, filing jointly.) Your marginal tax rate is the rate on the top dollar of taxable income. Thus, if your taxable income is $150,000 your marginal rate is 28%. (Your overall or average rate is much lower because some of your income is taxed at 10%, some at 15%, and some at 25%.) Thus, assuming a $150,000 taxable income, a $1 deduction would save you 28 cents in taxes.
Example--If your income, before any deduction for the equipment purchase is $150,000, you could write off about $35,000 in purchases at 28%. But once your income drops below $114,650 (for 2003), you'll be in the 25% bracket and each $1 of deduction will save you only 25 cents. When your income drops below $47,450 (2003) you'll be in the 15% bracket and that $1 deduction saves you only 15 cents in taxes.How do you get the biggest deduction? You generally want to try and level out your income from year to year. If your income is $300,000 one year and $20,000 the next, you'll usually pay more in taxes than if your income was $160,000 in both years. That's particularly true if you're consistently near a bracket breakpoint, or will break through a bracket.
Going back to the example above, assume you purchased $60,000 in equipment. You could write off the entire amount in 2003. But some of those savings would be at 28%, some at 25%. In addition, you'll have passed on a depreciation deduction in 2004 and future years, possibly pushing you into a higher (30%) bracket in those years.
You can level out your equipment purchase deductions (Sec. 179 and depreciation) in several ways. First, you can elect the Section 179 expense option on just part of the purchase price. Second, you can elect to take the 50% additional depreciation or the 30% additional depreciation or no additional depreciation for any class of assets. You might also consider defering an equipment purchase to the following year.
Creating an NOL. If the purchase is large enough and your business or individual income small (S corporations, partnerships, and sole proprietorships have to consider the owner's income), the writeoff could create a net operating loss. Net operating losses can be carried back 2 years and forward 20. If that happens, you've got to analyze your tax rates in prior and future years. Creating an NOL makes sense if you had very high income in the year to which the loss will will be carried back. Carrying forward a loss makes less sense since you really don't know what your future tax situation will look like.
Phaseouts. The tax law provides a number of benefits that are phased out (for individuals) as your income increases. Some of these phaseouts are common (the phaseout of itemized deductions and personal exemptions); some apply only to a small group each year (e.g., the adoption credit). For married taxpayers filing jointly, $100,000 may be the number to keep in mind. Several tax benefits are phased out at adjusted gross income above this level. To make things more complex, some of the benefits are lost forever, some can be used in another year. For example, the $25,000 loss allowance for rental income from actively managed properties is phased out between $100,000 and $150,000 of adjusted gross income. But any amount disallowed in the current year can be carried forward and deducted in a subsequent year. On the other hand, the Hope and lifetime learning credits cannot. Claiming a large depreciation deduction in one year may allow you to claim a credit you might not otherwise if qualified for. Or it could mean losing a credit.
Example--In 2003 you have three children in college. Except for the adjusted gross income limitation, you would qualify for $4,000 in credits. Your adjusted gross income is normally $150,000. You wouldn't qualify for the credit. However, your S corporation (or partnership or sole proprietorship) purchased a $70,000 machine. If you write off the entire cost this year you'll get the $4,000 credit for this year. If you take the normal depreciation you won't be able to take the credit this year or probably in future years. Here, the credit takes precedence over any tax rate savings.
Example--Assume the facts are the same as above, but your adjusted gross income is normally only $100,000. Take a $70,000 writeoff in 2003 and your adjusted gross income would be $30,000. After exemptions and deductions, your taxable income is $10,000, or a tax of $1,000. The $4,000 of credits will offset your $1,000 in taxes, but the remaining $3,000 of credits would be lost. You'd be better off to take much less depreciation in 2003.
Example--Assume the facts are the same as above, but your adjusted gross income is normally $110,000. If you spread out your depreciation deductions, you might be eligible for the credits the entire four years of college. Take a big deduction in 2003 and you lose a substantial part of the credit for 2003 (because you don't have enough tax) and you still might not be able to take the credit for the other three years.There's no rule of thumb here. You've got to work through the numbers. One way to do so is with a tax program. But keep in mind that some of these rules change from year to year. You may not be able to get the maximum, but you can effect substantial tax savings.
Self-Employment tax.If you do business as a sole proprietorship or partnership, you owe the self-employment tax on your net earnings. The tax rate is 15.3%, but because you get a deduction for half of the amount on your individual taxes, the effective rate is slightly lower. In addition, after you reach the maximum income level of $87,000 for 2003 ($87,900 for 2004), the rate drops to 2.9% (Medicare only). How you spread the deduction can be even more critical here. If the Section 179 and depreciation deductions result in a net loss for the business, you'll lose at least some of the benefit of reducing your self-employment income. That can never be recovered.
On the other end of the spectrum, if your self-employment income is consistently above the maximum earnings level, you might want to maximize your deductions in one year. That would allow you to go above the threshold in the next year. For example, your Schedule C income is consistently about $100,000 a year. Assume the maximum earnings for FICA are $85,000 and you can take up to $90,000 in Section 179 and accelerated depreciation. By taking the $90,000 in the first year you'll only pay the self-employment tax on $10,000 of earnings. In the second year you'll be above the threshold of $85,000 by $15,000. If you level out the deductions you might not break the FICA threshold in one or more years.
Depreciation Recapture
The Section 179 expense option and all depreciation reduces your basis in the asset. That's not a concern until you sell, abandon, or otherwise dispose of the asset. For example, you purchase an SUV for $40,000 and write off the entire amount in 2003. Your basis in the vehicle will be zero. In 2005 you sell the vehicle for $30,000. Since your basis is zero, you'll have taxable income (all ordinary income) of $30,000. If you're in a lower bracket in 2005 than in 2003, you'll have permanently saved tax dollars. On the other hand, if you're in a higher bracket, the government will come out ahead.
If you can plan the sale of assets such that they can be done in a year when your income is low, take as big a deduction up front as you can. If you can't forecast the year of sale, you might want to be more cautious on claiming the maximum deduction in the year of purchase.
Transferring the asset to personal use is generally treated the same as a disposition. And you must recapture any Section 179 deduction on autos and other listed property in the year the business use no longer exceeds 50% of total use. The rules can be involved here. Check with your tax advisor.
Basis in S Corporations and Partnerships
The Section 179 deduction (and depreciation) reduce your basis in S corporations and partnerships, even if you can't use the deduction on your personal return. That can be a problem, if you take distributions or the business repays debt owed to you before your basis is restored. For example, in 2003 Madison Inc. (an S corporation) has very little net income but takes a Section 179 deduction. As a result your basis drops below zero. In 2004, your basis is not restored, but you take a distribution and Madison makes principal payments of $5,000 on a loan. As a result, the distribution is taxable and the $5,000 is ordinary income. This is a complex area. Talk to your tax advisor about the implications.
Previously Reported In Daily Update
Price and sales may not correlate . . . When a dress shop charges less than the competition, unit sales increase. But that's not true for every business. For many service businesses, particularly those where there's a personal relationship, customers often don't comparison shop. In fact, they may not care what your competition charges. Evaluate your business carefully. You may be able to increase prices without losing customers.
Gift cards can expire . . . Read the fine print when buying (or getting!) a gift card. Some expire after a certain period of time (often a year). Others may incur fees if not used within a certain time period. One card we know of has a $2.50 per month charge if not used in the first 6 months. Thus, at the end of 8 months a $25 card is only worth $20. There may be other restrictions.
Employer-provided health coverage for domestic partners . . . Even if your employer pays the full amount of premiums for an accident or health plan for you, your spouse, or your dependents, the coverage is not taxable income. The same is true for reimbursements paid by your employer for medical expenses. But what about same-gender domestic partners? An employee's same-gender domestic partner does not qualify as the spouse of an employee. Thus, the value of health and accident coverage provided by an employer to a domestic partner is taxable to the employee. In a recent letter ruling (LR 200339001) the facts were slightly more involved. The employer's plan provided that an eligible dependent for purpose of the medical plan included an employee's same-gender domestic partner. Under the plan, employer and employees share the cost of the medical and dental coverage for employees, spouses and dependents (other than domestic partners). With respect to domestic partners who do not qualify as dependents under Section 152, taxpayers compute the taxable portion of the benefits provided to a domestic partner and include that in the employee's gross income. Prior to a domestic partner's enrollment in the medical or dental coverage, the employee and domestic partner must complete and have notarized a Domestic Partner Affidavit to certify the authenticity of the domestic partner relationship. The employer requires an annual recertification to confirm the status of the domestic partner relationship. Employers also require that the employee and domestic partner certify that the domestic partner qualifies as a dependent if the requirements of Section 152 are met. If the domestic partner qualifies as a dependent, the employer will not include the value of the domestic partner medical and dental coverage paid by the employer in the employees' gross income. The IRS held that medical and dental coverage and reimbursements that are provided to a domestic partner who qualifies as a Section 152 dependent of the employee is excludable from the employee's gross income under Section 106 and Section 105 and are not included in wages for employment tax purposes. With respect to a domestic partner who does not qualify as a dependent, neither the employee nor the domestic partner will include in income any amount received as payment or reimbursement under Section 104(a)(3) to the extent the coverage was paid for with after-tax employee contributions.
Job hopping may accelerate . . . For businesses, if there was a plus side to the slow down, it was reduced job hopping by employees and the lower raises that you could give and still keep an employee. With the economic pickup, that could change. It may be too late to be nice to employees you've wronged. While you may not be able to do serious planning since you don't know if an employee will look or what their chances of finding a new job are, you should be more alert to signs of unrest and start looking at options. This can be trickier because your basis in the new and old contract will have to be calculated.
Re-electing S corporation status . . . You can elect S corporation status at any time during the life of a corporation. You don't have to do so only when starting up. (However, to be effective for a particular year, you must make the election within 2-1/2 months of the beginning of the year.) Revoking S corporation status can also be done. However, generally, once you've revoked S corporation status, the corporation (and any successor corporation) can't re-elect to be an S corporation for 5 years. There are exceptions to the rule. The IRS may permit the corporation to make a new election before the 5-year period expires. The corporation has the burden of establishing that under the relevant facts and circumstances, the IRS should consent to a new election. The fact that more than 50% of the stock in the corporation is 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. (The new shareholders generally can't be related to the old shareholders.) That was the situation in a recent letter ruling (LR 200334035). The IRS granted the corporation consent to re-elect S status. (Note. You'll have to request a letter ruling. That will cost you in several ways.)
Compensation to trustees not self-dealing . . . The payment of compensation (and the payment or reimbursement of expenses) by a charitable organization to a disqualified person for personal services can result in self-dealing. The act of self-dealing can be subject to a heavy excise tax. In a recent letter ruling (LR 200342008) the trustees of a private foundation expended considerable time and expense in defending a foundation created and funded by an estate from a challenge by other claimants. The IRS held that the compensation received for the legal services provided by the trustees was reasonable and necessary and there was no self-dealing.
Extension granted to elect credit period for low-income housing credit . . . The deadlines for making some elections are cast in stone. Others may be extended at the discretion of the IRS. In letter ruling LR 200333011 the IRS granted the taxpayer an extension of time to make an election under Sec. 42(f)(1) for the credit period for the low-income housing credit. The taxpayer, a limited partnership, asserted it had inadvertently failed to make a proper election for the appropriate taxable year. The IRS found that the taxpayer met the requirements of Secs. 301.9100-1 and 301.9100-3.
Selling your business? . . . Or a division or product line? Avoid overshopping it. If you hire a broker, he may want to advertise it heavily or even put it up for auction. That could be a bad approach. If too many potential buyers realize the operation is for sale, they may get the impression you're having trouble selling it. That negatively affect the sales price and the number of offers. If your customers, competitors, etc. don't know the operation is for sale, getting too much exposure could make them suspicious and decide to seek another vendor. If you can't sell the business that'll reduce your profits; even if you do sell, it could have a negative impact. Best approach? You can avoid overshopping by picking potential buyers who might be interested and have the money. There's a good chance you or someone you know has a short list of prime candidates. Approach only a few candidates at a time. If they don't pan out, you can move on. You might be able to feel out potential candidates by, for example, starting a casual conversation at a trade show.
Partial exchange of annuities tax free . . . If you don't like the insurance company that sold you your annuity, you might want to consider changing companies. But if you cash out the policy, the excess of the amount received over your investment is fully taxable. The law (Sec. 1035) allows you to exchange one annuity for another. The insurance company will cash you out and forward the proceeds to the new company. As long as you don't have control over the funds, the exchange will be nontaxable. You can also do a partial exchange of policies. For example, you have $100,000 in one policy and decide to transfer $50,000 to a new annuity with another insurance company. In a recent letter ruling (LR 200342003) the IRS provided guidance on a partial exchange of a variable annuity contract for a deferred annuity, holding that the exchange was tax free. In addition, the ruling details the computation of bases.
High yield bond funds may not be . . . High yield bond funds are supposed to generate a better return because they invest in riskier issues. That's great if the fund manager picks the right issues, or you own the fund during a time when the economy is doing well. In those situations defaults (i.e., losses) are at a minimum and you'll see most of the high yields on the individual issues. If the manager picks poorly or there are many defaults, the returns will suffer. The result? The average of high yield funds has actually produced a much lower return over a 10-year period than a fund made up of much safer issues. While you could end up with a fund that outperforms the averages and/or get out before defaults hurt the fund's performance, you might be better off just putting your money in a safer fixed income fund.
Copyright 2003 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536