News On The Tax Front--The latest tax news.
Goodwill Entertaining Not Deductible--Pure goodwill entertaining is not deductible. And there's a special rule that disallows a deduction for hunting, fishing, and boat trips, etc.
Investment Interest --You can still deduct interest, for debts other than a mortgage or home equity loan, but only if it's related to investments, and then only if you meet certain rules.
Contract Negotiation Costs Had to be Capitalized --This taxpayer was forced to capitalize the costs of negotiating long-term contracts.
Accrual Method and Hybrid Accounting--In one case the taxpayer was on the accrual method, but deducted expenses in one year where the benefit extended beyond the end of the tax year. In the second case the taxpayer claimed to be on the hybrid method, but the Court did not agree.
Employee Training--Employees in need of training? Here are some options with some cost-saving tips.
In Brief:--Tax, business, and personal finance tips.
Previously Reported In Daily Update
The IRS continues to attack businesses that use the cash method of accounting and force them to use the accrual method if they maintain inventories. In Osteopathic Medical Oncology and Hematology, P.C. (113 TC--, No. 26) the IRS asserted a medical treatment facility had to use the accrual method of accounting since they used drugs in their treatment of cancer patients. The IRS claimed the drugs constituted inventory items. The Court disagreed. The Court noted that the drugs were transferred to the patients only as a part of the treatment and that the drugs could not be sold directly. The fact that the bills contained an itemized list of the drugs used did not change the results. Moreover, the fact that the drugs were a material income producing factor did not automatically mean they were classified as merchandise that had to be inventoried.
The IRS has issued proposed regulations with respect to the rules for determining a taxpayer's last known address. The issue is critical when sending notices that are time sensitive to taxpayers. Generally, the proposed regulations provide that the taxpayer's last known address is the address that appears on the taxpayer's most recently filed and properly processed federal tax return, unless the IRS is given clear and concise notification of a different address (use Form 8822). The regulations also provide that the IRS can use an address obtained from the U.S. Post Office as the last known address in the absence of a more recent address.
Don't have a mailing receipt showing you filed your return? You could have a problem. In Beverlee Cochrane (T.C. Memo. 1999-378) the taxpayer was unable to convince the Court she filed returns for 4 years at issue. Her testimony was uncorroborated and the Court found it self-serving and unconvincing. Since the Court found she hadn't filed returns, the statute of limitations was still open. Note. The courts are sometimes convinced by the testimony of another party, such as your accountant or attorney, but don't count on it. Mail it certified or registered, return receipt requested. You can also use one of the private delivery services (e.g., UPS, FedEx, etc.) but only certain of those services qualify. We've got a list of Private Delivery Services.
You can be reimbursed for your legal fees if you take the IRS to court and win. Well, that's the short story. The rules are definitely more complicated. In Reese B. Belshee, Jr. and Betty J. Belshee (T.C. Memo. 1999-380) the taxpayers sought to recover costs incurred in trying to prevent the IRS from levying on their assets. The Court sided with the IRS. It found that the costs incurred were not those that could be recovered.
The IRS recently announced (IR-1999-98) that it is sending out about 11 million postcards to taxpayer this month, inviting them to file their return electronically. The postcards contain e-file customer numbers (ECNs) that the recipients can use as signatures on returns they file electronically, eliminating the need to mail paper signature documents. In 1999, when the pilot program began, the IRS received 660,000 returns using ECNs. In addition, the IRS expects to select more than 18,000 preparers for the coming year's pilot, more than double the 8,100 it chose last year. Ten private sector organizations are partnering with the IRS to submit nominees for the pilot. The IRS selects preparers based on the credentials they have established as electronic return originators.
In Charles A. Nerad (T.C. Memo. 1999-376) the Tax Court agreed with the IRS in refusing to abate interest on a deficiency despite the fact the taxpayer's employer failed to provide him with an accurate W-2. The taxpayer had even attached a statement to the return indicating there was an error.
Your IRA account may not be safe from levy by the IRS. In Helen Kopec, Plaintiff v. Donald Kopec as Trustee of Dak Pension Plan (99-2 USTC 50,952; U.S. District Court, East. Dist. N.Y.) the IRS levied on the IRA of a delinquent taxpayer. The taxpayer's wife filed a wrongful levy suit to recover the half of the proceeds that represented her benefit in the account. The Court did not agree. Note. This is a complex area. Participants and spouses have certain rights under ERISA but the IRS can levy on pension assets.
Two old revenue rulings (Rev. Rul. 66-9 and Rev. Rul. 73-51) hold that you can claim a casualty loss with respect to timber only if the destruction is total. If the destruction is not total, the loss can only be taken when the timber is sold. In light of two court decisions (Westvaco Corp. and Weyerhaeuser) the IRS has decided to revoke those rulings. For complete details, see Rev. Rul. 99-56.
Rev. Proc. 99-46 provides revised specifications for the magnetic or electronic filing of Form 8027, Employer's Annual Information Return of Tip Income and Allocated Tips.
In a recent issue we discussed net operating losses (NOLs) and electing to carry them forward rather than back. That can save taxes if you were in a low bracket in the earlier years. However, the election is irrevocable. In John M. Harding and Mary J. Harding the taxpayers tried to argue that they didn't intend to make the election. The Tax Court said the statement they attached to their return clearly indicated their intentions and the election to forgo the carryback couldn't be revoked.
The IRS has issued regulations that deal with S corporations that have become a member of a consolidated group of corporations. Under the new regulations, a separate return as a C corporation for the day of the acquisition by the member of the consolidated group is no longer required. Now an S corporation will have just two short year returns. The first one is for the period ending on the day the S corporation joins the group. The second one is for the remainder of the year the corporation is a member of the group.
IRS Announcement 99-112 corrects certain errors which appear in Rev. Proc. 99-29 which provides specifications for filing Forms 1098, 1099, 5498, and W-2G magnetically or electronically. The Announcement also makes corrections to forms.
The IRS is almost finished conducting a study of electronic commerce with respect to the compliance of small business taxpayers. The study examined about 18,000 commercial web sites operating in several markets including retail, wholesale, financial services, etc. Of the total, the IRS looked at 1,600 businessws in more detail. In about 10% of the cases, the IRS was unable to identify the owner of the site. The IRS performed audits of 429 sites. Of those, 27% owed additional taxes. The most frequently encountered issue was that 65% of the taxpayers wrote off development costs of the site. Such costs have to be capitalized and amortized. The IRS also found that about 10% of the internet service providers the IRS examined had not filed a tax return.
You've probably heard of someone who said he doesn't pay taxes because he's taken a vow of poverty. Does it work? No way. The courts have consistently sided with the IRS. In Paul I. Yoshihara, Laura L. Yoshihara, and Krista A. Yoshihara (T.C. Memo. 1999-375) the taxpayers claimed a vow of poverty and purportedly assigned their income to a religious organization. The Court held that the income and the responsibility for paying tax remained with them.
In the same case (Paul I. Yoshihara, Laura L. Yoshihara, and Krista A. Yoshihara; T.C. Memo. 1999-375) the Court disallowed all the taxpayer's claimed business expenses. They presented no documentation to substantiate the deductions. Furthermore, while the Court said it would have allowed some expenses under the Cohan rule, the taxpayers provided no basis that would allow the Court to estimate their expenses.
Many private aircraft aren't owned by just one individual or business. Rather, they're owned by a group of individuals or businesses, often through a partnership. The partners share the fixed costs of operating the plane and pay a fee based on the hours of usage. In TAM 199946005 the IRS held that the monthly fixed charges and the hourly use charges paid by the partners for use of the aircraft are subject to the excise tax on amounts paid for taxable transportation under Sec. 4261. That's true even if an employee of one of the partners acts as pilot of the aircraft. Remember, technical advice memoranda and private letter rulings can't be cited as precedent. Check with your tax adviser on the course of action you should take.
The IRS has just announced the circumstances under which it will treat a contract as an annuity contract described in Secs. 403(a), 403(b), or 408(b) even if the contract premiums are invested at the direction of the contract holder in publicly available securities. Details are contained in Rev. Proc. 99-44.
In Internal Revenue News Release IR-1999-94 the Service announced that it is signing agreements with various electronic filing providers in the private sector to test improved methods of detecting fraudulent tax returns. Preparers will use enhanced tax software to facilitate their screening process and report potentially abusive returns to the IRS. For details see available in the Electronic Services section of the IRS web site, www.irs.gov.
The IRS has announced that it will once again use a debt indicator that will inform electronic return filers whether or not a requested refund will be reduced as a result of a debt owed to the IRS, to the Treasury's Financial Management Service, or both.
In IRS News Release IR-1999-95 the IRS announced it plans to start testing a system for handling taxpayer account questions through a secure internet web system. The systems will rely on secure communications technology known as public key infrastructure. For the test the IRS will select 100 National Association of Enrolled Agents from a list of volunteers the association submitted. A participant must have a power of attorney from the client and must obtain the client's approval to use the system.
If you're audited and the IRS disallows certain deductions, you may be able to avoid the 20% substantial understatement penalty if you adequately disclose the deduction on your return. For example, you take a charitable contribution deduction for property you donated. On audit, the IRS disallows $300 of your $900 deduction, claiming you overvalued your contribution. On your return you completed Form 8283 (Noncash Charitable Contributions). While you'll owe the additional taxes and interest, you should be able to avoid the substantial understatement penalty because you adequately disclosed the deduction. Had you just put the item on your return without completing Form 8283, you'd be liable for the penalty. In Rev. Proc. 99-41 the IRS updated the rules under which disclosure on a return will be adequate. Note. That doesn't mean you can take phony deductions and avoid the penalty.
In Ralph E. Wesinger, Jr. and Catherine R. Wesinger (T.C. Memo. 1999-372) the taxpayer lost on two hobby loss issues. In the first, the Tax Court sided with the IRS on disallowing their losses with respect to an airplane rental business. While they showed some profits, the Tax Court said they were due simply to chance. That didn't help their case. The Court also denied them deductions for a cattle ranch, noting they spent little time at the activity.
Goodwill Entertaining Not Deductible
Because of the potential for abuse and the possible personal nature of entertainment expenses, the rules for deducting such items are tougher than for other expenses. No deduction is allowed for an activity generally considered to constitute entertainment, amusement, or recreation, unless the taxpayer can prove the item was directly related to, or, in the case of an item directly preceding or following a substantial and bona fide business discussion (including business meetings at a convention or otherwise), that the item was associated with the active conduct of the taxpayer's business.
An expenditure for entertainment will be considered directly related to the active conduct of the taxpayer's business if it is established that it meets all of the following:
1. At the time the entertainment expenditure is made the taxpayer had more than a general expectation of deriving some income or other specific business benefit (other than the goodwill of the person or persons entertained) at some indefinite future time from the making of the expenditure.2. During the entertainment period to which the expenditure is related, the taxpayer actively engaged in a business meeting, negotiation, discussion, or other bona fide business transaction, for the purpose of obtaining such income or other specific benefit.
3. In light of all the facts and circumstances of the case, the principal character or aspect of the combined business and entertainment to which the expenditure related was the active conduct of the taxpayer's trade or business. It is not necessary that more time be devoted to business than to entertainment to meet this requirement. The active conduct of a business is considered not to be the principal aspect of combined business and entertainment activity on hunting or fishing trips or on yachts and other pleasure boats unless the taxpayer clearly establishes to the contrary.
4. The expenditure was for a taxpayer and a person or persons with whom the taxpayer engaged in the active conduct of business during the entertainment.
Some quick notes are in order. First, see item 3, above. Hunting, fishing, and boat trips are automatically disallowed unless you can prove that the principal reason for the trip was business. Overcoming such a presumption is usually very difficult. Second, if there are substantial distractions associated with the entertainment (e.g., where the entertainment is at a night club, theater, sporting event, or where you meet with a number of people other than business associates, i.e., you invite business and social acquaintances to the same function) the entertainment is considered not directly connected with your business. Third, while rule one above means you must expect a definite benefit at some definite time in the future, you may still be able to secure a deduction if the entertainment is associated with the active conduct of your business. Briefly, to be deductible under this rule the entertainment has to be directly preceding or following a substantial and bona fide business discussion. for example, you spend all afternoon with a customer discussing the specifics of a sale. You take him to dinner and a show. The entertainment is associated with the business discussion and is deductible.
In one case (Charles E. Magowan and Kathleen M. Magowan, T.C. Memo. 1994-152) the taxpayer was a self- employed loan broker who took several clients on fishing trips to British Columbia. The taxpayer used such trips to maintain good personal relations with existing clients and for advertising, client promotion, and entertaining. One of the trips was used to reconcile a relationship with a former client.
The Court held that the taxpayer did not maintain more than a general expectation of deriving some income or other specific trade or business benefit other than goodwill. Thus, the taxpayer failed the first test in the list above. The Court noted that the law was written to disallow this type of activity, which involves merely the promotion of goodwill in a social setting.
Since you must pass all four tests to secure a deduction, the Court didn't have to go further. However, it did and noted that the taxpayer also failed the third test in that he did not clearly establish that the principal character of each trip was the active conduct of his trade or business. While the taxpayer testified that his companions were long-time clients, and the business was discussed with the clients on each trip, the testimony could not overcome the presumption that the principal purpose of the trip was not business. (Remember, hunting, fishing, and boat trips have a different standard.)
Most businesses have a regular pattern of entertaining. For example, technology companies are big on trade shows and conventions, publishers frequently try to win over advertisers with meals and theater or sporting events, etc. Talk to your accountant to make sure your current entertainment expenses are deductible. And check with him again when you're considering entertainment expenses in new areas. There have been a number of changes in the last 10 years, so don't rely on past experience.
Personal interest (e.g., credit card interest, car loan, etc.) hasn't been deductible for years. For individuals, basically only three types of interest are currently deductible:
What's investment interest? Basically, it's interest on money borrowed and used to buy property you hold for investment. However, you can never deduct interest on any amounts borrowed to purchase or hold property that produces tax-exempt income, e.g., municipal bonds. And investment interest doesn't include any interest taken into account in computing income or loss from a passive activity.
Investment property. Property held for investment includes property that produces interest, dividends, annuities, royalties or gains on disposition that are not associated with a trade or business. The most common examples are corporate stock, bonds and other debt instruments, shares in a mutual fund or real estate investment trust, etc. Investment property also includes an interest in a trade or business activity in which you did not materially participate. Special rules apply to a passive activity.
Example--You own 100 shares of AT&T. That's considered investment property. So is 1,000 of Madison Inc., a corporation in which you own a 90% interest.
Allocation of interest expense. If you use borrowed money for business or personal purposes as well as for investment, you must allocate the debt among these purposes. Only the interest expense on the portion of debt that is used for investment purposes is treated as investment interest. Generally, the allocation is not affected by the use of property that secures the debt. For example, you borrow $10,000 putting up your stamp collection as collateral. However, fully deductible home mortgage interest is not treated as investment interest and the debt does not have to be allocated, regardless of how the proceeds are used.
Example--You borrow $20,000 and use $18,000 to buy stock. You use the other $2,000 for personal expenditures. Since 90% of the debt is used for (and thus allocated to) investment purposes, 90% of the interest on that debt is investment interest. The other 10% is personal interest and not deductible.
The example simplifies how the allocation is made. In practice, doing the allocation can be much more complicated. That can be a topic all to itself. We'll just deal with the most commonly encountered situations here.
If you deposit debt proceeds in a bank, money market, etc. account, that deposit is treated as an investment expenditure. Amounts held in the account are treated as investment property, regardless of whether the account bears interest. Any interest you pay on the deposited loan proceeds is investment interest. However, if you withdraw the funds and use them for another purpose, you must reallocate the debt and any interest you pay.
Example 1--On June 1 you borrow $20,000. The lender deposits the money directly into your checking account. On June 30 you purchase $18,000 worth of stock. You leave the remaining $2,000 in the account until September 1 when you use the funds as a down payment on a new car. Assume you made no other transactions in that account and made no principal payments on the debt. The $18,000 is treated as used for investment purposes from the date the money is deposited in the account, even though you did not buy the stock for 30 days. In addition, the $2,000 is treated as being used for investment purposes during the 3-month period until withdrawn for personal purposes. Your total interest expense on this debt for the 3 months from June 1 to August 31 is considered investment interest. However, in September you must begin to allocate 90% of the debt and the interest expense to investment purposes and 10% to personal purposes.
When is an amount considered to be taken out of an account? In the case of a checking account, it's on the date the check is written, as long as the check is delivered or mailed within a reasonable time. If you write a number of checks on the same day, you can treat them as written in any order.
As you repay the debt you must reallocate the balance. Fortunately, you must first reduce the amount allocated to personal purposes by the repayment. You then reallocate the rest of the debt to find what part is for investment purposes.
Example 2--Using the facts from example 1, above, you repay $500 on December 1, the entire repayment is applied against the amount allocated to personal purposes. The debt balance is now allocated as $18,000 for investment purposes, and $1,500 for personal purposes. Until the next reallocation is required, 92.3% ($18,000 divided by $19,500) of the debt and the interest expense is allocated to investment purposes.
Example 3--Assume the facts are the same as in example 1, except that on August 1 you write a $6,000 check for a personal expenditure. No other transactions are made in the account for the remainder of the year. From June 1 through July 31 you can treat the entire $20,000 as allocated to investment purposes. From August 1 through the end of the year $6,000 of the debt is considered allocated to personal purposes and $14,000 is for investment purposes. Thus, the interest for that period is considered 30% ($6,000 divided by $20,000) personal interest.
Tax Tip--You can see from this simple example that calculating your tax deduction can get complicated quickly if you have even one personal expenditure from the loan proceeds during the year. It may make sense to set up a separate bank account just for receiving the loan proceeds and disbursing them for investment purposes.
Different rules apply to loan proceeds received in cash. Generally, you must treat such amounts as used for personal purposes. A 30-day exception applies. If you make a cash expenditure within 30 days, you can treat the expenditure as being made directly from the loan proceeds.
Tax Tip--Avoid taking the proceeds in cash if possible. You'll have more flexibility and less IRS hassel if the loan is deposited directly into your account. Even better, use a separate account strictly for investment purposes.
Deducting investment interest. The first requirement, as with any deductions for cash basis taxpayers, is that you must pay the interest before you can deduct it. And, if you pay interest in advance for a period that goes beyond the end of the year, you must spread the interest over the tax years to which it belongs.
In the case of a margin account, you are considered to have paid interest on the account only when you actually pay the broker or when payment becomes available to the broker through your account. Payment may become available when the broker collects dividends or interest for your account, or sells securities held for you or received from you.
The amount you can deduct for interest expense you paid or accrued during the year to buy or carry a market discount bond may be limited. This limit does not apply if you do not accrue the market discount and include it in your income currently.
Limit on deduction. If you've passed all the hurdles above, there's one more. Unfortunately, it's the biggest. Generally, your deduction for investment interest expense is limited to your net investment income for the year. Any amount not used in a year can be carried forward and used in future years.
Your net investment income is equal to your investment income less your investment expenses.
We gave you a brief definition of investment income above. It's income from property held for investment. Generally, that means dividends on stocks, interest on savings and money market accounts, bond interest, etc. (It doesn't include Alaska Permanent Fund dividends.)
Investment income also includes short-term gain on the sale of property less any long-term capital losses. But long-term capital losses can't reduce short-term gains below zero. Net short-term losses don't reduce your investment income.
To compute net investment income, you've got to subtract your investment expenses. These are any allowed expenses (but not interest expense) directly connected with the production of investment income. These expenses can include investment publications, fees paid to a financial planner, etc., but not brokerage commissions. They're part of your basis in determining your gain or loss on the sale of securities. If these investment expenses were deducted as a miscellaneous expense (the most likely situation), the amount you have to include here is the lesser of the investment expenses on line 22 of Schedule A, or the total on Schedule A, line 26 (after adjusting for the 2% floor).
Example--You had $2,500 in investment expenses on Schedule A and another $100 in other miscellaneous expenses. Your adjusted gross income was $100,000, so your deduction for these expenses was limited to $600, the amount over the 2% floor ($2,000 here). In this case your investment expenses are only $600.
Computing the interest deduction. A few examples should clarify much of the detail discussed above.
Example 1--Fred Flood has investment interest expense of $6,000 for 1999. He has investment income from the following sources:
Interest from savings account $ 250
Dividends on stocks 500
Regular mutual fund distributions 300
Total $1,050
In addition, Fred has investment expenses of $600. His net investment income is $450 ($1,050 less investment expenses of $600). For 1999 he can only deduct $450 of his investment interest expense. The remaining $5,550 must be carried over to future years.
Any investment interest not deductible in the current year can be carried forward indefinitely. You do similar computations in the following year to determine the amount deductible.
Tax Tip--The ability to carry forward the amounts makes it sound like the limitation isn't a concern. But if your investment interest expense is significant and your investment income minimal, your carryforward amount could become larger each year.
Investment gains and losses can affect your investment income. Net short-term gains increase investment income. Long- term gains usually don't, but you can make a special election. See below.
Example 2--The facts are the same as in example 1, above, but Fred has $5,000 in short-term losses. The losses have no effect on the computation; his net investment income is the same, $450.
Example 3--The facts are the same as in example 1, but Fred has $5,000 in short-term gains (he has no long-term gains or losses). The $5,000 in short-term gains is added to his investment income, resulting in net investment income of $5,450. Now his interest deduction is limited to $5,450.
Example 4--The facts are the same as in example 3, but Fred also has $3,000 of long-term capital losses. The losses offset some of the short-term gains, leaving him with $2,000 in net gains. Thus, his net investment income is $2,450.
You can make an election to have long-term capital gains count as investment income, but you'll have to sacrifice the favorable 20% rate. That is, the gains will be taxed at ordinary income rates. In effect, you're gaining a deduction for your interest, but paying higher rates on the gain. In making the election you specify how much of those gains you want to apply.
Tax Tip--Even though unused investment interest expense can be carried forward, it could be years before you can use it. You might want to take some short-term capital gains to generate additional investment income. But that may only make sense if you're worried about the stock declining or need the cash. As always, investment considerations should be paramount. While important, taxes should take second place.
Tax Tip--Making the election to use your long- term gains is even trickier. You'll be trading the lower capital gain rate for an immediate interest deduction. The choice may make sense if you're in the 15% or 28% bracket, (since there's not much of a spread between your regular and capital gain rates 10% vs. 15% and 20% vs. 28%) and there's little chance you'll have enough investment income in the next few years. Talk to your tax and financial advisers and work through the numbers before doing anything.
Other points. The discussion above assumes you're an investor and not a trader in securities. We can't go into the definition here. We'll do that in an upcoming article. However, if you're a day trader and that's your only source of income, you're probably not an investor, but a trader. In that case there's no limitation on your interest deduction.
The above rules also apply to interest on money borrowed to purchase the stock of, or make loans to, any C (regular) corporation. That includes a closely held one. For example, you borrow $200,000 to invest in a C corporation in which you're the only shareholder. You can only deduct the interest on the loan up to the amount of any investment income you have.
Tax Tip--If the company borrows the funds and you just guarantee the loan, the company gets the deduction. Thus, it pays to fund the company with as little of your personal funds as possible. There can be some disadvantages, so discuss the issue with your tax and financial advisor first.
This rule doesn't apply to S corporations and partnerships in which you materially participate. Any interest on borrowings to fund an equity investment or loan to the business are fully deductible on Schedule E of Form 1040.
If you have an interest in an S corporation or partnership your K-1 will have a line for the amount of investment income passed through to you, another line for the investment expenses, and a line for investment interest. Add these amounts to your personal investment income and expenses.
Income or expenses that you used in computing income or loss from a passive activity are not included in determining your investment income or investment expenses.
Finally, while the deduction is taken on Schedule A of Form 1040, you'll need to complete Form 4952, Investment Interest Expense, to compute the amount of interest deductible. Check the instructions to see if you have to attach the form to your return.
Contract Negotiation Costs Had to be Capitalized
The IRS continues to find additional expenses that they deem must be capitalized rather than deducted currently. One of the most recent examples involves a Technical Advice Memorandum (TAM 199952069). (While a TAM doesn't have the effect of a revenue ruling and can't be cited as precedent, it does show IRS thinking on an issue.)
The situation involved a company that regularly entered into long-term (10-year) contracts. The IRS agent argued that the costs (mainly employee compensation and travel) incurred in soliciting, evaluating, and negotiating the contracts had to be capitalized. The taxpayer, obviously, claimed the amounts should be deductible as incurred. Five contracts were involved. While all were different, each generally provided that the taxpayer would hire the other party's employees and use them to provide services to that other party. Some of the contracts were amended after they were entered into and one was terminated early.
Generally, an expenditure is capital if it creates or enhances a separate and distinct asset or if the expenditure produces a significant long-term benefit. While the mere fact that a taxpayer may receive some future benefit from an expenditure does not require capitalization, a taxpayer's realization of benefits beyond the year in which the expenditure is incurred is an important factor in determining whether the expenditure is deductible in the year incurred or capitalized.
The expenditures here created long-term contracts. Long- term contracts are considered to be capital assets subject to amortization and depreciation (Sec. 263). In one case (Stewart Title Guaranty Co.; 20 T.C. 630) the court held that "a contract which is expected to be income-producing over a series of years is in the nature of a capital expenditure which must be amortized ratably over the life of the asset or the period of the contract." The contracts need not necessarily be profitable, just as long as they were intended to produce a continuing economic benefit over a period of years. The fact that some of the expenditures are poor investments doesn't make any difference. In another, more recent, case (Lykes Energy; T.C. Memo. 1999-77) the Court required amounts that the taxpayer characterized as promotional and selling activities to be capitalized where the direct object of the expenditures was obtaining new customers. The important point here is that amounts spent for promotional and selling activities may not be automatically deductible.
The taxpayer argued that a current deduction should be allowed because capitalization would have little effect on the taxpayer's total salary and related expenses and, thus, would do little to improve the clear reflection of the taxpayer's income. (Any adjustments the IRS makes to a taxpayer's accounting methods must be to "clearly reflect income.") The reasoning is based on the recurring nature of the amounts at issue. The IRS rejected this argument, noting that the Tax Court rejected a similar argument in PNC Bancorp.
Finally, the taxpayer argued that costs incurred prior to the bid award date should be deductible. The IRS did not agree. It cited a Tax Court decision (Norwest Corp.; 112 T.C. No. 9) where the taxpayer was denied a deduction for preparatory costs incurred before the formal decision to proceed with a transaction. The Court held that the fact the costs were incurred before a formal decision was made did not change the fact that the costs were related to a capital transaction.
What does this mean? If you're audited an agent could require you to capitalize costs that you might have considered deductible selling expenses but that are expected to produce benefits over a number of years. That could include building your customer base, particularly if the benefits extend beyond a year. A classic example is that of a utility that provides a subsidy to homebuilders to install gas appliances in order to gain new gas customers. Once the utility has a new customer, the benefits will accrue over a number of years. The same logic could be applied to building traffic to a web site. On the other hand, while you hope a newspaper ad will bring not only immediate but long-term traffic to your retail store, the long-term benefits are a minor consideration.
Should you be worried? Is there anything you can do? Fortunately, there's a good chance an agent won't bring up the issue. That's particularly true if the long-term nature of the benefit isn't obvious; that is, you don't have long-term contracts, you're not losing money to build a customer base, etc. There isn't much you can do, but you should try to maintain a low profile. The less obvious the costs, both in size and nature, the less likely you'll have to capitalize them. More than likely, the costs in the situation above were significant in relation to the company's overall selling expenses.
If you capitalize the expenses for financial statement purposes but expense them on the tax return, you're asking for trouble. You'll not only make it easy for an agent to spot the issue, you'll poison your case. Generally, your tax books should agree with your regular books.
In the case of contracts you might consider writing them for a short period of time, say 2 years, with an attractive renewal option. If the salary and other expenses have to be capitalized, you may be able to write them off over just 2 years. That's not nearly as bad as 5 or 10 years.
Talk to your tax advisor. He may have other suggestions.
Accrual Method and Hybrid Accounting
In two recent cases taxpayers lost in Tax Court on accounting issues.
In the first case (USFreightways Corp.; 113 TC--, No. 23) the taxpayer was a trucking company that incurred $4.3 million for licenses in 1993. None of the licenses covered a period of more than one year, but some of them extended beyond the end of the taxpayer's tax year. The company also paid $1 million for liability and property insurance coverage, which also extended into the next tax year. Again, none of the policies covered a period of more than one year, but the policies covered the period from July 1, 1993 to June 30, 1994--6 months in one tax year and 6 months in another.
The company used the accrual method for federal income taxes, book accounting, and financial reporting. In compiling its financial books and records the taxpayer expensed the amounts for insurance and licenses ratably over the 2 years at issue. That is, it deducted in the first year only the amount that applied to that year. Amounts not expensed were reflected as prepayments on the balance sheet. That's in contrast to what the taxpayer did for tax purposes, i.e., deducting the entire amount in the first year.
The Court noted that the general rule is that taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books. In this case the Court found that while the company used the accrual method for its books, it deducted the expenses in question under the cash method, clearly in contravention of the rules. The Court also noted that there are recognized exceptions to the conformity of financial and tax accounting. However, none of the exceptions applied here.
The taxpayer argued that the benefit of the expenditure didn't extend more than one year beyond the end of the tax year. The Court said that's not the issue. The test is whether the benefit of the expenditure extends beyond the end of the accounting period. Thus, a deduction for an insurance payment made for the period December 1, 1999 through November 30, 2000 would be limited to 1/12 of the total in 1999 and 11/12 in 2000.
Note. The rule is different for a cash-basis taxpayer with respect to insurance expenses. Cash-basis taxpayers typically have been obligated to capitalize payments for insurance with terms in excess of 1 year, but, for insurance covering 1 year or less, a full deduction in the year of payment has been allowed.
This is one area where it doesn't make sense to be aggressive. The issue is too easy to spot and it's almost a certainty an agent will make an adjustment. Moreover, you could find yourself subject to penalties. If you're uncertain of the proper treatment, check with your tax adviser.
In the second case (Howard G. Grider, et ux. T.C. Memo. 1999-417) the taxpayer was a logger who used a hybrid method of accounting for 40 years before he was challenged by the IRS. A hybrid method of accounting is one combining the cash and accrual methods. The law (Reg. sec. 1.446-1(c)(1)(iv) allows a taxpayer to use any combination of cash and accrual methods if such combination clearly reflects income and is consistently used. A taxpayer using an accrual method with respect to purchases and sales may use the cash method in computing all other items of income and expense. However, a taxpayer who uses the cash method in computing gross income from his trade or business must use the cash method in computing expenses of the trade or business. Similarly, a taxpayer who uses an accrual method of accounting in computing business expenses must use an accrual method in computing items affecting gross income from the business.
The taxpayer incurred $114,823 of repair expenses for logging machinery and equipment in 1994. However, because he had a dispute with one of his suppliers, he paid $51,203 in 1994 and $63,620 in 1995. He deducted $94,723 in 1994. (He did not deduct the full $119,723 because he wanted to increase his income for social security purposes.) The Court found that the taxpayers did not report income until they received it, but they deducted some expenses before they paid them. The taxpayers argued that this was a proper hybrid method of accounting which they have consistently applied.
The Court disagreed. It held they must deduct expenses in the taxable year in which the expenses are paid. They paid $63,620 in 1995, so that's the year they could deduct them, not in 1994. The Court also found that the method they used did not clearly reflect income. Thus, the IRS had the power to change their accounting method.
In addition, the Court upheld the negligence penalty.
Many businesses find that their employees need additional training--either specific training in industry skills or training in basic skills such as reading and math. While the problem has existed for some time, it has become more critical with the increasing importance of technology in the job place.
What are your options?
Previously Reported In Daily Update
Auto insurance deductibles . . . You know you can reduce your insurance premiums if you increase the deductible on your policy. The flip side, of course, is that you'll be out of pocket that amount should you have an accident. If the car is in your personal name only the amount in excess of 10% of your adjusted gross income (AGI) (plus $100) is deductible on your personal return. If you're AGI is $100,000, you'll get no tax benefit for the first $10,100 of any uncovered loss. But that's not true if the car is owned and used 100% by your business. There's no such floor. If you've got a $2,500 deductible, you can take a tax deduction for the full amount. Weigh the annual cost savings against your increased exposure.
Audit chances declining . . . IRS Commissioner Rossotti recently told a Senate Governmental Affairs Subcommittee that the number of audits and collection procedures for the current fiscal year will decline some 30% to 40% from the pace of two years ago. But he also warned taxpayers that they shouldn't misinterpret these comments.
Reduce your risk . . . Insurance premiums are based on the amount of risk the carrier thinks he's undertaking. You may pay more for having a dangerous breed of dog, storing more than a certain amount of gasoline in your garage, keeping an unregistered car, having a pool, etc. On the other hand, you should get a reduction for smoke and carbon monoxide detectors, burglar alarm, etc. Talk to your insurance agent to determine which items may apply to you. The savings can be substantial.
IRS publications updated . . . The IRS has released updated versions of Publication 531, Reporting Tip Income; Publication 54, U.S. Citizens and Resident Aliens Abroad; and Publication 911, Direct Sellers.
Invest monthly . . . You've probably heard the advice about putting money in your IRA as early as possible in the new year. If you wait the 15-1/2 months until April 15 of the following year when you file your tax return, you'll have lost out on that much interest. Do it every year and you'll have given up a big chunk of money. When it comes to your other investing, putting aside money on a monthly basis will also increase your return. For example, invest $2,000 a year at the end of every year at 8% and you'll have $28,973 at the end of 10 years (assumes no taxes). Invest the same amount, but do it monthly ($166.67 per month) and you'll have $30,491 at the end of 10 years. Why the extra $1,500? Simple. Since you're investing monthly, some of your money is earning interest for 12 months, some for 11, etc. At the end of 20 years the difference is significantly larger. Invest $2,000 once a year and you'll have $91,524; invest a similar amount monthly and you'll have $98,170- -$6,600 more. The more you invest or the higher the return, the bigger the difference. Another plus. If you're investing in the market you'll be dollar averaging. That usually works to your advantage.
Save taxes--create more income . . . Sounds foolish? It's not. You can often run into situations where generating taxable income can actually save in the long run. That generally happens when your income for the year is so low that you've got deductions and/or credits that won't be used. For example, you're starting a new company. You're not taking a salary but have two children in college. You're entitled to $2,500 in education credits, but after your itemized deductions, your taxable income is actually negative. If not used this year, those credits are worthless. You could have up to $20,000 in income before paying a dime in taxes. What to do? In some cases you might be able to shift income from 2000 to 1999. If not, consider converting some traditional IRA money into a Roth. You'll pay no tax on the additional income, and distributions from the Roth when you retire will be tax free. The approach also works if you're in a low bracket this year (say 15%) but normally pay tax at 28% or more. Work through the numbers first, of course. Caution. If you have an net operating loss, you may be better off carrying the loss back or forward rather than using the approach above.
IRS Publications updated . . . The IRS has announced that two publications, 553, Self-Employment Tax and 225, Farmer's Tax Guide, have been updated and are available online.
Company policy statements critical . . . A number of employees at one company were recently fired for sending and receiving e-mails that were sexually explicit. Could your company fire employees for such actions? If you did and you had no stated policy prohibiting the acts, you could find yourself in trouble. E-mail, while clearly an important issue today, is just the tip of the iceberg. Company policy should address this and a host of other issues. You can start with a "canned" policy manual available at some office supply stores, on disk, etc. But don't adopt it blindly. The policy statements should be in writing and distributed to all employees.
Payroll service or do it yourself? . . . There are two considerations here. First, the cost. There's a fixed and a variable component to the service. Most payroll services will charge a relatively large amount if you have only one employee, but the price per employee falls quickly as you put more employees on the payroll. If it's only you and one or two other employees, you know the ins and outs of payroll accounting, and you've got some extra time, you might want to go it alone. However, as the number of employees rises, you'll probably do better with a service. The second issue involves internal control. If you use an outside service the risk of an employee embezzling from the business is greatly reduced; and payroll is one of the prime areas for defalcations. Avoiding that risk could be worth much more than the cost of the service.Holiday gifts . . . Your deduction for business gifts is generally limited to $25 per individual. The limit applies to customers, suppliers, etc. You might consider taking them to dinner and/or a show. You can only deduct 50% of the amount, but there's no limit. You can generally give a holiday turkey or ham to employees and deduct the full cost without having the value included in their income. But if you want to make a more substantial gift, you've got to include the value on their W-2. You might be better off with a small gift and a bonus, or a company dinner.
Copyright 1999 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