January 2005

Sales Tax Deduction

The IRS has just released Publication 600: Optional State Sales Tax Tables for preparing 2004 returns. This information is not found in the IRS instructions for the Form 1040. For 2004 and 2005 only (as the law stands at this moment), if you file Schedule A, itemized deductions, you have the following choice—you can deduct the greater of:

1.       State income tax withheld (which also, of course, includes estimated taxes paid to the state during that taxable year),  or

2.       The state and local general sales tax deduction.

If you deduct your state and local general sales tax deduction, you can deduct the greater of:

1.       Your actual sales taxes paid, or

2.       The applicable amount from the Optional State Sales Tax Tables provided in Publication 600.

Again, this deduction provides a choice: the state income tax or the sales tax. If you live in a state that does not impose a state income tax, such as Texas , the decision is already made—deduct the sales tax. In other states, it will be necessary to calculate both of these amounts in order to determine the maximum benefit.

The office will tend to use the Optional State Sales Tax Tables, but you are encouraged to provide a total from your actual receipt records. If you choose to provide your receipts, please retain your actual receipts for a minimum of 3 years.

Some jurisdictions may have different sales tax rates for different classes of purchases. Publication 600 provides that: sales taxes on food, clothing, medical supplies, and motor vehicles are deductible as a general sales tax, even if the tax rate was less than the general sales tax rate. Further, sales taxes on motor vehicles also are deductible as a general sales tax if the tax rate was more than the general sales tax rate, but the tax is deductible only up to the amount of tax that would have been imposed at the general sales tax rate.

Expanded Provisions

If you do use the table amount, you can add to that any state and local general sales taxes paid on:

1.       A motor vehicle (including a car, motorcycle, motor home, recreational vehicle, sport utility vehicle, truck, van, and off-road vehicle),  and

2.       an aircraft, boat, home (including mobile and prefabricated), or home          building materials, if the tax rate was the same as the general sales tax rate.

Further, if you use the table, the office will use your total available income to determine your expenditures, (not just your income which is taxable). Total available income includes nontaxable items such as: tax-exempt interest, veterans’ benefits, nontaxable combat pay, workers’ compensation, the nontaxable part of social security and railroad retirement benefits, public assistance payments, and the nontaxable part of IRA, pension, or annuity distributions.

Purchases for business don’t count

The Publication makes clear that you should not include sales taxes paid on items used in your trade or business. Why? Because these taxes are included in the basis of the business asset, which asset is then depreciated (allocated over a span of years), or deducted using either what is called Section 179 expensing or the 50% bonus depreciation as part of the depreciation calculation.

Paper or plastic? State income tax or sales tax? No matter which, the office promises to “bag” you the grea test tax benefit!

Reporting Foreign Financial Interests

 In October of this year President Bush signed the American Jobs Creation Act. This act covers a broad range of provisions. One of these provisions affects a taxpayer’s responsibility to report, accounts with a foreign financial institution.

This reporting requirement applies to accounts which exceed $10,000 in value at any time during the year. The failure to do so results in hefty penalties and even potential imprisonment! In general, any U.S. citizen or resident who has a financial interest, signature or other authority over a bank or securities account or other financial account located in a foreign country is required to report this interest to the U.S. Treasury Department.

How is this reported?

The information is reported on Form TD F 90-22.1 and is due June 30^th of the following calendar year. The information that this form requires includes the name of the financial entity, account number, maximum value held during the calendar year, type of account and other informational items.

Civil Penalties for Noncompliance

In the past, the Treasury Department would impose a civil penalty for intentional or willful violation of these reporting requirements. Under the new law, the civil penalty applies whether the violation is willful or not. If the violation is deemed unintentional, the maximum civil penalty is $10,000. The law allows for a waiver of the penalty if the violation was due to reasonable cause.

Violations deemed willful carry a much larger penalty. The penalty ranges from the lesser of $100,000 or the value in the account at the time of valuation to the greater of $100,000 or 50% of the value of the account! There is no reasonable cause waiver for intentional noncompliance.

Criminal Penalties

In addition to the civil penalty, a taxpayer could also be liable for criminal penalties. The criminal penalties can amount to a maximum of $250,000 and potential imprisonment if the taxpayer is found to have willfully violated the reporting requirements. The amount of the penalty increases to $500,000 if the violation reflects a pattern of illegal activity.

Avoid paying these large penalties.

If you have a foreign bank account interest, you will need to disclose this interest on Schedule B of your income tax return. Moreover, as stated above, you will have to file Form TD F 90-22.1 by June 30^th. Unlike individual income tax returns, these filings cannot be extended. The American Jobs Creation Act imposes harsh penalties for failure to comply with the reporting requirements of foreign financial accounts. These penalties apply not only to failure of reporting but also to failure of timely reporting. Thus ensuring that you are in compliance with the filing requirements and deadlines to avoid the risk of depleting what you are keeping offshore.

Interesting

We know that qualified residence interest is deductible on Schedule A, Itemized Deductions. Qualified residence interest is actually composed of two parts:

 Acquisition Debt and Home Equity Debt

Acquisition debt is debt which is secured by the residence and is borrowed to acquire, construct, or substantially improve a primary and/or secondary residence. It is deductible on indebtedness up to $1 million, whether you have one home or two.

Home equity debt is secured by the residence, but is not acquisition debt. It is deductible on indebtedness up to $100,000, assuming there is sufficient equity in the home(s). Home equity is not used to acquire, construct, or substantially improve a primary and/or secondary residence.

Home equity debt can be used for any purpose, and the interest is still deductible as qualified residence interest on Schedule A. A typical example would be borrowing $50,000 for a personal family vacation. The interest on this, assuming it is a loan secured by the residence, is deductible on Schedule A.

Beyond the Obvious

Let’s take a step back: Interest paid, other than in regards to qualified residence interest, is or is not deductible, depending on the use of the proceeds. The proceeds must be traced to the use. If, for example, you borrow money for use in your sole proprietorship, Schedule C, the interest would become deductible business interest. If you borrow money using a signature loan for a personal vacation, it is personal interest and not deductible. With qualified residence interest, specifically with home equity interest, it is not mandatory to trace the use of the proceeds. The interest is always deductible on Schedule A.

Maximizing the Benefit

However, there comes a time when you might prefer to trace the use of the proceeds from a home equity loan to maximize your tax benefit, and not be content to merely deduct it as an itemized deduction. This can be done under Regulations 1.163-10T(o)(5)(i) (we are not kidding!).

Example: You borrow $50,000 against your home, but you use the money in your Schedule C, your own business. If you make the election above, the interest is deductible on Schedule C instead of Schedule A. This is better. Why? The deduction on Schedule C saves income tax and self-employment tax. Sometimes the self-employment tax (Schedule SE) savings are more than the income tax savings. In addition, any deduction on Schedule C reduces the adjusted gross income (AGI). A deduction on Schedule A only reduces taxable income. A deduction on Schedule C does not result in alternative minimum tax. A deduction on Schedule A can contribute to alternative minimum tax. The tax savings are substantial. You are much better off tracing the use of the proceeds, in this scenario.

Hence, when you do refinance or borrow money against the house, the office needs to speak with you and analyze the proper treatment for the maximum tax benefit. A few extra minutes spent will result in the most beneficial determination.

Your interest comes first

This deduction of interest is interesting, but remember that as your tax advisor, the office has first and foremost in mind, your interest!  

December 2004

Year End Charitable Gifting

The holidays bring out the philanthropic in us all. At the end of the year, we make charitable contributions. Is this a good thing? Absolutely, yes; if you file Schedule A, and itemize your deductions, instead of claiming the standard deduction, you will save income tax. If you make a donation of cash or property to a charity, you get a deduction. The amount you deduct for cash is, of course, the cash amount. That is, if you donate $500, you deduct $500. More problematical is what amount you deduct when you donate other than cash. Suppose you donate house wares? How much do you deduct? The answer is that you deduct the fair market value. Some think of this as a thrift shop value and, for the present, this definition is a useful one.

Proper Timing of Deductions

Be aware of the rules that determine when a donation is considered to be made. Checks are deductible when mailed. If you mail a check to a charity on December 26, 2004 , it is deductible in 2004 even if the charity does not cash the check until early January 2005. Credit card charges are deductible when charged. If you make a donation by credit card on December 26, 2004 , and the charge is made on that day, the deduction will be for the 2004 tax year, even if you do not pay off the credit card bill until February 2005. This is for a simple reason: When you charge a credit card, the credit card makes payment to the charity. So, when you charge on December 26, 2004, the charity receives the money at that time. You have, in effect, borrowed from the credit card, but you have paid the charity. It is not terribly important when you pay back the credit card company.

Non-Cash Contributions

If you make the donation of house wares to Goodwill or Salvation Army or your favorite charity on December 26, 2004 , you will deduct the “thrift shop value” on your 2004 tax return. If the value of the house wares exceeds $500, I will need to complete a Form 8283 for you. If the non-cash charitable contributions exceed $5,000 for an item or group of like items, you will need to provide me with an appraisal performed by a qualified appraiser. I can guide you on this.

The law is changing on the donation of vehicles.

The recent Jobs Creation Act, signed by President Bush on October 22, 2004, has new restrictions on deducting the donation of used motor vehicles, boats, and planes. Some history is in order here. The General Accounting Office issued a report last year that indicated that when individuals donate automobiles, the value claimed is far in excess of what the charity receives. In one especially egregious example, a donation of a car was deducted in the amount of $3,950. However, an intermediary sold the vehicle for $300 and the charity received only $5. Unbelievable. This overvaluation so bothered Senator Grassley, Chairman of the Senate Finance Committee, that he made the following statement.  “This report further exposes what’s proving to be a rat’s nest of problems in the area of aggressive valuation of in-kind gifts.” In response to this, the new law provides that for donations of used motor vehicles, boats, and planes made in 2005 (NOT 2004) the donation shall not exceed the gross proceeds received by the charity from such sale. In the example above, had the car been donated in 2005, the charitable deduction would have been limited to $5, the amount the charity received.

Take advantage of the old rules in 2004.

Now, don’t panic. This restriction applies for donations made in 2005 and subsequent. If you donate a used motor vehicle, boat, or plane this year, in 2004, the deduction will be the fair market value. I will need to know the condition of the car and will review www.kbb.com, for Kelley Blue Book, or will check other listings to provide an accurate determination of the fair market value.

Donations of cars are absolutely fine and permitted. The IRS just wants to insure reporting of the fair valuation. There are record keeping requirements that I will be pleased to discuss with you.

Perhaps, rather than donating your car, you should sell it and then donate the cash proceeds. Please speak with me to discuss what will make the most sense.

Making charitable contributions is not only a good thing to do for many ethical and religious reasons; it also contains deductible tax benefits. I want you to obtain all of your proper tax benefits. The new law change isn’t meant to prevent your donative intent; it merely wants to insure that the proper fair market value is taken. And it is hard to argue that the proper fair market value is other than what the charity does receive. It makes sense.

Given the further new law restriction on the donations of used vehicles applying for 2005, it might make sense to make the donation in 2004. The year is almost over. This is one transaction you need to discuss with me immediately. If you wait until 2005 it will be too late to correct a poorly structured or timed donation. I look forward to helping you NOW.

I also wish you a very wonderful holiday season and the very best wishes for the coming year.

And, Now, A Bit of Bad News

During the holiday season, it is not unusual for a business to give a gift to its important clients. These gifts are, of course, a business expense and are tax deductible. If you have a sole proprietorship, the deduction will be taken on Schedule C. That much is clear and easy to understand.

Where is the bad news? Code Section 274(b) provides a limitation on the amount of the deduction. So you do not “shoot the messenger” here are the words directly out of the mouth of Congress:

(b) Gifts

(1) Limitation

No deduction shall be allowed under section 162 or section 212 for any expense for gifts made directly or indirectly to any individual to the extent that such expense, when added to prior expenses of the taxpayer for gifts made to such individual during the same taxable year, exceeds $25.

Does this mean that you can only deduct $25 for a business gift per client? In a word, Yes. In two words, Yes, Yes.

Isn’t the amount of $25 a bit anachronistic? Isn’t this a limit that was enacted many decades ago? Indeed, this is true. But, remarkably, this is still what the law states today.

If you provide your client a business gift whose cost is $83, you can only deduct $25.

Happy Holidays from the Internal Revenue Code.

May the balance of your season be happier than this news, but someone had to tell you.

All right, you are angry. To vent your anger, I’ll say the magic words with you: Bah, Humbug!

Year End Tax Planning

December is a month that is dominated by shopping, holidays, and family times. In the midst of all these enjoyable activities, make sure you allocate some time for tax planning. There are often steps you can take to minimize your taxes for the year, but most of those steps must be taken before the year end.

The Tax Projection

The foundational step to effective, year end tax planning is the creation of an accurate tax projection. The time spent compiling information for the projection is not lost time, as the information will also be used in the preparation of your final return. My office would like to help you with your year end projection. For many taxpayers, the cost of the consultation will be more than offset by the tax saved. If you feel comfortable doing your own year end projection, be sure you consider the potential effects of the Alternative Minimum Tax (AMT) and the effect which the amount of your Adjusted Gross Income (AGI) has on the various phase- outs of deductions and credits. The amount of your AGI and your potential liability for AMT are basic to any decisions you make to minimize taxes.

Timing of Income and Deductions

A significant part of good year end tax planning has to do with proper timing of income and deductions. To do this you need to think about what you expect for next year. If your AGI is high this year and you expect it to be lower next year, you may want to defer income to next year and/or accelerate deductions into this year. The goal, of course, is to keep your taxable income in a lower bracket in both years if possible.

How can you defer or accelerate income? Answers will vary depending on your circumstances, but following are some general suggestions. You may be able to take a taxable, year end pension distribution in late December or early January. If you are planning a sale of assets, be sure it closes at an advantageous time. Prepaying or deferring deductible expenses such as state and local income taxes, property taxes, interest, contributions, etc. can also be effective techniques. Schedule the purchase of business equipment to your best advantage, keeping in mind the effect of changes to the tax code. This can be especially helpful in increasing expense for 2004 since the first year bonus depreciation will not be allowed in 2005.

Remember that your decisions may change if you are subject to AMT. For instance, prepaid state income taxes will not reduce AMT, and you will actually lose part or all of the deduction permanently if you prepay them in a year in which you owe AMT. Taxpayers with Incentive Stock Options (ISO’s) must also take into account the effect of the AMT when deciding when to exercise the options. There are several other items which play into the AMT equation. Let me help you work this out to your best advantage

“Harvesting” Portfolio and Property Gains and Losses

Many taxpayers currently have capital loss carry-forwards from prior years. These can be offset by gains on stock or property sold. If you have assets you want to sell and the sale will result in a gain, time the sale so as to take advantage of these losses. If your portfolio transactions show accumulated gains, look for investments which are currently showing losses and consider selling those assets to offset the gains. Two words of caution here: 1. Make sure that your decisions make economic sense aside from the tax consequences. Saving taxes, by selling assets with good, upside potential may not be a wise decision. 2. In general, property sold at a gain should be held more than one year before selling, so that any tax owed may be at long term capital gain rates.

Elective Pension and IRA Contributions

Consider the effect of making contributions to 401-k plans, pension plans, and/or IRA’s. 401-k plan contributions are especially valuable if your employer matches any part of your contribution. In general, pension contributions reduce AGI so they can be effective in minimizing deduction and credit phase-outs, and in maximizing medical deductions and those miscellaneous itemized deductions subject to the percentage of AGI floor.

Give it Away

The first article in this newsletter dealt at length with charitable giving, and, of course, gifts given to charitable organizations can reduce your taxes. Remember however, that you may be subject to a phase-out of your itemized deductions if your AGI is too high. Don’t forget that donating appreciated stock to a charity allows you to avoid the payment of any tax on the appreciation and allows the charity to realize the full appreciated value of the stock.

Gifting appreciated stock to someone who pays tax at a lower rate than you do (Children and grandchildren qualify.) is generally more advantageous than selling the stock and gifting the proceeds, net of tax, to that individual. There may be an exceptional benefit if the individual receiving the stock can wait until 2008 to sell it. (Ask my office about this.) The gifting of appreciated assets is also an effective technique for removing the assets from your estate and minimizing estate taxes.

Remember that donating vehicles in 2004 will provide a much larger benefit that in 2005. This also was covered in more detail in the previous article.

What about funding for college?

Now is a good time to check up on the status of funds you have set aside for college. Are the funds growing at a rate that will provide a sufficient nest egg when needed? Are you taking advantage of the available, tax deferred methods of saving for college? If not, you may be able to reduce this year’s tax bill and add to your college funds at the same time.

Help is available.

As you can see, there is a lot to this tax planning. Get your information organized and make an appointment to come to my office for a planning session as soon as possible. Enter the new year with the confidence that you have done everything you can to properly manage your tax bill for 2004.

October/November 2004

Section 179

Time for another lesson in the Internal Revenue Code. The topic for today is Code Section 179. 

When you acquire an asset for use in your business and the asset will provide use over several years, the cost of the asset is typically recovered over those several years by spreading the cost. This “spreading of the cost” is what we know as depreciation. The Internal Revenue Code has specialized rules for depreciation using a system titled the Modified Accelerated Cost Recovery System. Section 179 allows the taxpayer the option of expensing the entire cost of the asset in the year it is purchased. Yes, there is a limitation on the total amount which can be expensed in any one year, but the limitations are liberal enough to provide a significant tax benefit for those taxpayers eligible. Section 179 has been in effect for several years, but new Regulations have been issued which provide even greater flexibility than was the case previously.

The current limitation

For tax year 2004, the amount that can be expensed under Section 179 is $102,000. If you have assets exceeding that amount, the balance of the cost of the assets will be depreciated over the useful life of the asset.

The new flexibility

The major change made by the Regulations is the ability to amend an already filed return to claim Section 179 where on the original return you did not claim Section 179, or to revoke the election. The Regulations provide some background to this: Small business taxpayers are often unaware of the advantages or disadvantages of section 179 expensing. Some taxpayers may not have been aware of the section 179 election until after filing an original Federal tax return. In addition, making the section 179 election is not always to a taxpayer's advantage. For example, the section 179 election may prevent the taxpayer from fully using exemptions and deductions, reduce a taxpayer's coverage under the social security system, and make various tax credits unusable.

Permitting taxpayers to make or revoke section 179 elections on amended Federal tax returns without the consent of the Commissioner reflects Congress' intent "that the process of making and revoking section 179 elections should be made simpler and more efficient for taxpayers." Such a process will provide flexibility to small business taxpayers in determining whether the section 179 election is to their advantage or disadvantage.

Details and specifics

Section 1.179-5T(c)(3) of the Regulations provides that any election under section 179, or specification of such election, for any taxable year beginning after 2002 and before 2006 for any item of section 179 property may be revoked by the taxpayer on an amended Federal tax return without the Commissioner's consent and that such revocation, once made, is irrevocable. Accordingly an amendment to add or remove an asset from Section 179 treatment can be filed once, but after that the amendment cannot be rescinded.

Bottom Line:

While many individuals might think that deducting as much expense as possible is always beneficial, this might not be the case. Sometimes the timing of a deduction is critical and accelerating the deduction may not make sense on your return. In such a case, if Section 179 was elected, a revocation should be considered. In other cases, perhaps an earlier year’s return depreciated an asset rather than expensed the asset. Maybe Section 179 should be elected on an amended return.

There are more details, of course, to this Code Section than we have the space to cover here. When you sit down to discuss your taxes with the office, we can review whether you should utilize the new flexibility provided by the Regulations.

Early to Rise

The opening facts of a recent court case, M.E. Yoakum, T.C. Memo 2004-191 are quite a grabber:

During 1978, 1979, and 1980, Mr. Yoakum invested in the stock market, primarily through the brokerage firm of Paine, Webber, Jackson & Curtis (Paine Webber). Douglas Osborne (Osborne), a Paine Webber employee, was his stockbroker. On each day that Paine Webber was open for business, Mr. Yoakum visited its office. He invested a total of approximately $500,000 to $1 million in speculative securities. Each day when Mr. Yoakum arrived at Paine Webber's office, usually between 6 and 6:30 a.m., he started drinking alcoholic beverages, supplied by Paine Webber. He would drink until he was high and happy but not stumbling drunk. He authorized each of his trades, and he was informed and knowledgeable as to all of his trades. Some of his trades resulted in gains, and some of them resulted in losses.

Blame the losses on the broker

During1980, Mr. Yoakum exhausted most of his funds, and he discontinued his regular involvement with Paine Webber. In or about 1985, Mr. Yoakum and his wife sued Paine Webber, Osborne, and others (collectively, the defendants) in a U.S. District Court, alleging that the defendants were liable for securities fraud, negligence, and breach of fiduciary duty in the handling of his accounts. The court did not really rule on the merits of the Yoakum’s case. Instead it dismissed the lawsuit for two reasons. The Yoakums had waited beyond the applicable period of limitations for filing and they had failed to plead properly as to fraud. That dismissal was affirmed by the Court of Appeals for the Ninth Circuit.”

Theft loss or investment loss?

Mr. Yoakum did lose about $800,000 investing in the stock market. He claimed the loss was a theft loss, not an investment loss. Even though he was not sustained in that position in his suit against the broker, he deducted the loss as a theft loss on his income tax return. A theft loss is treated as a casualty loss and can create what is called a net operating loss, which can result in a refund of taxes paid in earlier years and reduce the payment of taxes in subsequent years. A net operating loss is a very powerful tax benefit, but it has specific rules.

Can a stock investment loss be taken as a theft loss? The short answer is, typically not. In some cases, the answer is yes, but not in this case. While the court did not discuss the recent pronouncement, Notice 2004-27, this notice specifically disallows as theft losses a decline in the value of stock that was acquired on the open market for investment. The courts have consistently disallowed theft loss deductions relating to a decline in the value of a stock, even if that decline was attributable to corporate officers misrepresenting the financial condition of the corporation, even when the officers were indicted for securities fraud or other criminal violations.

The 6^th Circuit Court concurs

In the 1999 6^th Circuit Court case, MTS International Inc. v. Commissioner, an individual taxpayer sold at a loss, stock that was acquired on a public stock exchange and argued that the substantial decline in value was due to criminal conduct by the corporation's officers. The Sixth Circuit concluded that the loss was not a theft loss.

If the stock is sold or exchanged or becomes wholly worthless any resulting loss is a capital loss. The deduction for the loss is capped at $3,000 per year. This amount is the most that Mr. Yoakum was entitled to deduct on the return in question.

Managing Medical Expenses

Congress has designed policies to alleviate the burden of medical expenses, especially with the Baby Boomers aging and health costs rising. One of the newest provisions passed by our lawmakers is the Health Savings Account (HSA). Several months ago this newsletter included an article on HSAs. They continue to receive a great deal of attention in tax publications and in the press, and this article reviews and elaborates on their requirements and advantages.

Tax Advantages

HSAs allow you to shelter income from taxes and reserve it for medical expenses that are not covered by your insurance, such as co-pays, high deductibles or other out-of-pocket medical expenses. The HSA is a specialized account similar to an IRA account. Contributions to it are tax deductible as an adjustment to income rather than deductible as an itemized deduction. Accordingly the deduction is not limited by the 7.5% of AGI limitation. Distributions are tax free if used to pay for qualified medical bills.

The Rules

In order to be eligible for an HSA account, you must be covered under a high-deductible health plan and not be covered by Medicare or any other health insurance plan except for plans that cover long-term care, dental, vision and certain other medical costs. Also you must be less than 65 years old. A high deductible medical plan is defined as a plan which has an annual deductible which is at least $1,000 for self-only coverage and at least $2,000 for family coverage. In addition to the plan coverage limitations, there are contribution limitations. Each year the maximum you may contribute to an HSA is the lesser of your insurance deductible or a statutory amount. For 2004, these statutory amounts are $2,600 for self only coverage and $5,150 for family coverage. An example may help to make these limitations more clear. Madeleine and Antonio are both single and both have high deductible medical plans. Madeleine’s plan has a deductible of $3,000, and Antonio’s plan has a deductible of $1,500. The deductible contribution is the lesser of their deductible amounts or the amount set by law which is $2,600 for singles. Thus in Madeleine’s case, her deductible is $2,600 but Antonio’s is $1,500.

Individuals between the ages of 55 and 65 will be permitted an additional, “catch up” contribution. For 2004 this additional amount is $500. Thus in the example above, if Madeleine is between the ages of 55 and 65 she could contribute $3,100 ($2,600 plus $500). If you are an employee and you establish an HSA, you, your employer or both of you may contribute to it. If you have a cafeteria plan at your place of employment you may also designate cafeteria plan funds for your HSA. Of course, you will not be able to deduct your employer’s contribution on your personal tax return, but neither will you be required to recognize your employer’s contribution as income on your return.

An insurance company, bank or any other institution qualified to be a trustee or custodian of IRAs, can also be an HSA trustee or custodian.  Before you set up the account make sure that you have the requisite, high deductible plan in force.  Then be sure that the money is invested in such a way that it will be reasonably easy to withdraw the funds when you need them to pay expenses.

There are many other rules which apply to specific situations. Such issues as contribution deadlines, rollover contributions, the treatment of excess contributions, proper and improper distributions, treatment of accumulated funds in your estate, must all be considered. The office can help you sort out your individual situation. IRS Notice 2004-2, available on the IRS website, also provides a great deal of information. If you want to set up an HSA be sure you have comprehensive advice that deals with your specific situation.

The Benefits

One of the greatest benefits of having an HSA is that it can be established entirely on your own, unlike a flexible spending account (FSA) which requires your employer’s participation. Thus your HSA can stay with you from job to job, even if your employer has made contributions for you.

If you are an individual who typically has very few medical bills, and you have had to pay for your own medical insurance, the HSA gives you the advantage of the significantly lower premiums of a high deductible plan. The deductibles and co-pays cam be covered by withdrawals from you HSA account, and any funds not used from the HSA will be allowed to accumulate from year to year. Thus you benefit directly by avoiding unnecessary visits to your health care provider, and you still have adequate protection from catastrophic illness or accident. Both current contributions and accumulated funds are invested and the earnings are tax free and help build up the balance in the account. Distributions can be used for medical expenses, even after you reach age 65 and can no longer contribute to the account. At age 65 and later, distributions can be treated much like an IRA distribution. All of these benefits are in addition to a reduction in your tax bill.

If you are an employer who has not been able to afford a comprehensive health care plan for your employees, you may be able to participate with your employees in funding an HSA program at a cost that is significantly lower than paying conventional medical premiums.

The HSA is a plan that merits serious consideration, especially for those who find the current cost of medical insurance an extreme burden.

September

Documents You Should Keep

Many items that we deal with on a daily basis come with expiration dates printed on them. Some of these items show expiration dates to safeguard you. You see them on everything from packaged foods to medicine bottles. Discount and rebate coupons usually have expiration dates. Season passes to theme parks, recreational facilities, athletic events, etc. all come with a date of expiration. Unfortunately your tax source documents don't have expiration dates printed on them. What should be kept and what can be tossed? The real question is, when faced with a potential audit, what documents should you keep, and how long must you keep them in order to safeguard yourself from a nasty battle with Uncle Sam?

Fortunately there is an expiration date of sorts on your tax return. The Internal Revenue Service can audit your returns within a three year period. That period starts on the later of two dates: the date that the tax return is due (typically April 15th) or the date that the tax return is actually filed. As long as the tax return does not involve fraud, tax evasion, or a substantial understatement of income, the IRS has a three year window to ask you for supporting documents or proof regarding the numbers on your tax return.

Below are some general guidelines to keep in mind when deciding what documents you should keep for tax purposes.

Your tax return

Keep your tax returns indefinitely. They are a valuable source of historical tax information and provide a record of asset acquisitions and dispositions. Typically the IRS destroys the original returns after four to five years but nowadays with their updated systems, the originals may be scanned and kept as electronic files. In any case you should have copies of your original tax returns in case the IRS loses, destroys or purges your returns.

Cancelled checks, invoices, statements and receipts

Keep them for at least three years if the information impacts only that year's tax return. For example, cancelled checks to charities, summaries of your interest or dividend income and your mortgage interest paid usually affect only a single year's tax return.

Receipts for property improvements

Receipts that document property improvements could affect your returns many years from now when you decide to sell or rent your primary residence or dispose of rental property. These costs increase the basis of your property so ideally the receipts should be kept at least five to seven years after you finally sell the property. This means if you install a new roof, add a room or improve your home or rental property in other ways, you should retain these receipts even if you don't plan to sell the property for 5, 10, 20 or more years.

Our current law allows a married couple to exclude up to $500,000 of gain on the sale of their primary residence ($250,000 for a single taxpayer), but it is not impossible for the gain to exceed these exclusion amounts, especially in areas where property values have increased significantly. If you can document your improvements, you will be able to reduce or even eliminate the taxable gain. We also have no guarantee that congress will not change or eliminate this exclusion in the future.

Safeguard yourself from law changes and excess gain by keeping those receipts that may affect the gain calculation or the amount of depreciation on your home or rental.

Escrow statements

Escrow statements are very valuable in determining the basis of your home or investment. The escrow statement that shows your purchase should be kept at least three years after you sell the property. The escrow statement that shows the sale should also be kept at least three years after the sale of your property. These statements are needed to prove the calculation of gain or loss that you ultimately claim in the year of sale whether it is your primary residence or investment property.

Brokerage statements and confirmations

In general keep any documents that show confirmations of stock sales for at least three years. These documents allow you to document the proceeds received and dates of sales. To prove the calculations of your gains or losses, you need to keep the statements or confirmations of your stock purchases. If you bought shares in 1990 but did not sell them until 2004, you would have to keep documentation of the initial purchase for at least 14 years to establish your basis in the shares sold, plus an additional three years to protect yourself in the event of an audit of the year the shares were sold.

L ast word

In general, these guidelines cover only a select overview of the type of documents you should keep. For more information on record keeping you can review the IRS Publications 552 and 17, "Record keeping for Individuals" and "Your Federal Income Tax for Individuals."

Perhaps the best you can do to safeguard yourself against a potential audit is to keep everything when in doubt. If you are a packrat by nature this will be easy to do. If you are a minimalist, think of it this way -- keep the hassle of a potential IRS audit at a minimum by keeping those records handy.

Why Isn't Everything Deductible?

There is a recent, wonderful case about a Professor of Theater at Wayne State University in Detroit . The taxpayer's name is N. Joseph Calarco, and the case is T.C. Summary Opinion 2004-94, easily accessible at www.ustaxcourt.gov.

Half of this case deals with whether Professor Calarco can be both a professor, for which he receives a W-2, and an independent playwright, for which he files a sole proprietorship Schedule C. The answer to this question is that he can be both. The IRS raised the question since the Professor had many expenses in being a playwright and little income from that activity. The IRS argued that his lack of income from the activity indicated that he was not in the business of being a playwright. The court held otherwise, finding that he is a playwright. That's when the case gets really interesting.

Judges just want to have fun

The court opinion is authored by Tax Court Judge Mark V. Holmes who writes the court opinion like a play and uses many literary and theatrical references (check out the hilarious footnotes -- really!). When he determines which business expenses are deductible, he begins by answering the question: Why isn't everything deductible? Following are numerous, direct quotations excerpted from Judge Holmes opinion. Italicized entries have been added for clarity.

All taxpayers, even playwrights, are allowed to deduct
the ordinary trade or business expenses they incur
during the year. Internal Revenue Code Section
162(a). But this often leads to temptation. Our tax
court predecessor, the Board of Tax Appeals,
recognized more than 60 years ago that without
firm limits, taxpayers would seek to deduct:

"The fee to the doctor, but for whose healing service the
earner of the family income could not leave his sickbed;
the cost of the laborer's raiment, for how can the world
proceed about its business unclothed; the very home
which gives us shelter and rest and the food which
provides energy, might all by an extension of the same
proposition be construed as necessary to the operation
of business and to the creation of income."

In the following section the judge quotes from an unpublished, staged manuscript.  See the note below for his source.

Well, you see, Josh, now that you're not just a salaried
copy editor but also a freelance television critic, you can
file a Schedule C and deduct your legitimate business
expenses. . . .

So I went home, . . . and looked around my room. What
was a "legitimate business expense"? Okay, I'm a
television critic, so. . . the television!  Yes! Because I
need something to criticize!

Okay, so the television . . . And then -- yeah, the VCR,
because I can't watch every episode of "T.J. Hooker." .

And, of course, the videotapes. . . . And the replacement
labels for the tapes, which I get from Radio Shack. . . .
Oh! -- and the TV Guide, which guides me to the
television! . . . And the books of television criticismI've
bought.  And actually, the books I've bought that aren't
television criticism: they've still informed my criticism of
the television. . . . Oh! -- and the chair I sit in, of course:
very important what your posture is when you criticize a
television. And the food I eat -- which literally makes up
the cells that form the critic of the television.

J. Kornbluth, Love and Taxes (staged monologue re
income tax)(unpublished manuscript, 2003). (The Wall
Street Journal gave this show an excellent review.)

Petitioner has fallen victim -- at least at times -- to this
fever, claiming many quotidian activities, such as reading
newspapers and renting movies, to be "business-related".
He is, at some level of abstraction, no doubt correct. But
we must administer the tax laws as they are

Some expenses are deductible, some are not

The court then goes through each of his claimed deductions. A business expense is that which is ordinary and necessary. There needs to be specific nexus, connection, between the business and the expense. The IRS doesn't let you deduct everything.

Petitioner must in all cases provide evidence to establish a sufficient connection between the deduction and his trade or business.

The losers

Let's look at just two claimed expenses that the taxpayer lost in the audit:

The playwright deducted costs of watching plays, video rentals, and other performances. He test ified that every time he listens to a CD or watches a movie he is engaged in playwriting and not recreation. The court said: This suggests a less than candid assessment of his business expenses. Had petitioner test ified as to a particular difficulty with the plot or characters or language of his play that he sought to fix by watching a specifically selected play by someone else, that specific expectation would perhaps justify a deduction. Merely broadening one's horizons is not enough. (That last sentence is very powerful.)

Similarly, the taxpayer deducted newspapers and periodicals. The court stated: On petitioner's Schedule C, he claimed a deduction for $1,055 in periodical expenses. This entire amount is documented in his post trial submission. The documentation, however, shows that $838 of this total was spent on subscriptions to major newspapers. The cost of a "daily newspaper of general circulation is inherently a nondeductible personal expenditure", so we disallow these amounts. We also disallowed the $120 for subscriptions to PC World, PC Magazine, and Byte. Petitioner has not demonstrated to our satisfaction that his purchase of these magazines had a business purpose. Thus, the only deductions that we allow in this category are the $97 he spent to subscribe to Poetry and Gramophone.

So what can you deduct?

Mind you many of the expenses were allowed by the court. In considering claiming expenses, ask yourself whether the expenses are ordinary and necessary. Is it commonly incurred by similarly situated businesses? Is it appropriate and helpful? Is it specific to the business? If it is so general as to be a personal expense, such as commuting, food, lodging, and daily newspaper and basic phone service, it will not be deductible. Please keep good track of your income and expenses and feel free to speak to the office, even this time of the year, especially this time of the year.

August

Extreme Taxes

Newsweek, May 17, 2004 , had an interesting article on page 12 of that issue titled: Tax Trouble for ABC’s ‘Extreme’ Winners? The article spoke about the TV show Extreme Makeover: Home Edition and addressed a tax question—is the con test ant taxable on the fair market value of the renovations? Here is what they state:

 “The production company gave the Woslums (the con test ants) a letter saying its accountant believed the family didn’t have to pay taxes on their windfall, but when the family’s own accountant read it, he grew wary. “I’m living in fear and trepidation”, says accountant Brett Porter. If the IRS looks closely, he worries, the family could owe thousands in taxes.”

How could it not be taxable?

Remember that everything is taxable unless there is a code section that otherwise exempts it. The article said that the producers argue that it is tax-free since “the show leases participants’ homes, paying $50,000 for 10 days’ rental.” Now, there is a statute, Internal Revenue Code Section 280A, which provides, as explained in the accompanying regulations:

Short rental period

If a dwelling unit used by the taxpayer as a residence during the taxable year is actually rented for less than 15 days during the taxable year, no deduction otherwise allowable because of the rental use shall be allowed, and the rental income shall not be included in gross income.

It seems a very strained interpretation to state that the TV company is renting the property.

Code Section 74 clearly states, “Except as otherwise provided in this section or in section 117 (relating to qualified scholarships), gross income includes amounts received as prizes and awards.”

What about the value of the improvements?

If the prize is taxable and if the program is not renting the taxpayer’s residence for less than 15 days, how do they claim that the improvements made are not taxable? 

They would invoke Code Section 109 which provides: “Gross income does not include income (other than rent) derived by a lessor of real property on the termination of a lease, representing the value of such property attributable to buildings erected or other improvements made by the lessee.” 

So, says the TV Production Company, you can rent your house to us for less than 15 days, and the rent you receive is tax-free. During those 15 days, any improvements we make and leave will not be taxable to you. It stretches the imagination to think that this would be considered a short term rental and that any short-term rental, of less than 15 days, would have the lessee incur such substantial improvements.

Disagreement

The Newsweek article quotes a tax publisher who finds the TV company’s position lacking merit.

This office agrees. If you go on a game show, have your moment of fun. If you win, fabulous. But be prepared to pay the tax on the fair market value of the winnings. Now, what exactly the fair market value of the winnings is monetarily is a REAL issue. The Newsweek article has a picture of the winner in his nonworking shower. If you do a quick Internet search, you can read some interesting discussion threads about the “quality” of some of the work won on TV. The office can help you with determining your proper portion of tax, but it can’t entertain curious tax positions.

Scams and Schemes

Every year the IRS publishes its “Dirty Dozen” list. This is a list of the twelve most prominent tax scams, ranked in order of their prevalence. The IRS actively pursues and prosecutes those guilty of perpetrating these schemes, but it is important for taxpayers to be aware of them also. In general, be especially wary of anyone who says you don’t need to pay any taxes, purports to know of some obscure provision in the law supporting his position, and is ready to share his information for a fee.

Abusive Trusts

At the top of the list this year is the abusive use of trusts. Trust abuse has been prevalent for several years. In spite of numerous criminal prosecutions of those promoting the schemes, it continues to be a persistent abuse. The promotion of these scams is particularly insidious because the proper use of trusts, especially in estate planning, can effectively reduce the total amount of taxes paid. Promoters of these schemes find it easy to convince the unsophisticated taxpayer of their validity.

Trust scams take many forms and promise such benefits as the reduction of income subject to tax, the ability to write off personal expenses, the diversion of business income to foreign trusts, etc. Those who promote these trusts often charge high fees for their services. Taxpayers who participate in these schemes will pay the up front fees but then will end up paying the taxes they supposedly avoided along with significant penalties and interest. Before you enter into any trust type arrangements contact the office for advice.

Claim of Right Doctrine

This scheme is relatively new but has already risen to number two on the list.

It involves taking a deduction equal to the amount of wages on the return. It is based on a misinterpretation of the tax code.

Corporation Sole

This form of organization is used legitimately by some religious leaders to separate themselves from the control and ownership of church assets. Promoters of this scam have mistakenly twisted the rules into a means of avoiding federal taxes, child support payments and personal debts.

Offshore Transactions

Last years number one scam has dropped to number four this year. It involves offshore bank accounts, brokerage accounts, credit cards, wire transfers, trusts and employee leasing, etc. to hide or underreport income.

Employment Tax Evasion

Promoters of this ruse twist tax law to claim that it is not necessary to withhold employment taxes from employee’s wages. This misinterpretation has been refuted in court and its promoters subjected to criminal prosecution. Unsuspecting employers who fall prey to this scam may be liable for all the unpaid payroll taxes plus penalties and interest. Individual employees will still be liable for their share of the unpaid taxes.

Return Preparer Fraud

Unscrupulous return preparers advertise heavily, guaranteeing large refunds. They take a portion of the refund themselves and in addition charge inflated fees. Be assured the office does not engage in these practices.

Americans with Disabilities Act

Participants in this fraudulent scheme purchase equipment and services at an inflated cost from a promoter. The promoter alleges that they satisfy the requirements of the Disabled Access Credit. A minimal down payment is made and a note signed for the balance. The note is retired through the performance of insignificant services.

Slavery Reparations

This scam was number one on the list in 2002. Promoters claimed that the law made provision for reparations payments to the descendants of slaves. The promoters would charge fees for preparing the returns claiming the reparations. There is no such provision in the law and the claims filed are worthless.

Improper, Home Based Businesses

Set up a bogus, home-based business and write off personal expenses as business. This scam has been around for a long time, and it keeps showing up. A clear business purpose and a profit motive are necessary for a legitimate business.

Frivolous Arguments

This is another scam that won’t go away. Promoters claim to know the “secret” of not paying taxes, and they are willing to share it with you for a fee. Unfortunately there are no secret ways to avoid paying tax. Following the advice of these promoters can lead to civil and criminal penalties in addition to large tax bills.

Identity Theft

We all know of the danger of identity theft, but we don’t usually think of it as a fraudulent tax scheme. Unscrupulous individuals send out documents which appear to have come from the IRS in an attempt to get your bank and brokerage account numbers. Another scam takes the form of filing bogus tax returns using a stolen Social Security number. These returns typically generate large, refunds for the person filing the return.

Share/Borrow EITC Dependents

Winding up the list this year is an Earned Income Tax Credit scam. Unscrupulous tax preparers share the dependents of one family with those of another family in order to illegally maximize Earned Income Tax Credits on both returns. 

If it sounds too good to be true it is! There are no secret ways to avoid taxes. Communicate with the office before adopting any suspicious tax strategies or paying for unreliable advice. The ultimate price will be high and the consequences severe

July

Alternative Minimum Tax Strikes Again

Now that the office has survived tax season, we are sure that some of you have been hit by the alternative minimum tax. The alternative minimum tax, otherwise known as AMT, is a parallel, but alternative tax system, in which the tax base is broadened and a lower overall rate of tax is applied to your alternative minimum taxable income. If your alternative minimum tax is greater than your regular tax, then you pay the higher AMT. At its origination many years back, the purposes of the AMT were to have all taxpayers pay a fair share of tax and to ensure that those who took advantage of tax loopholes did not escape tax. The problem with AMT is that it has become so pervasive. It has even become the subject of tax parody. Really. In the 30^th Anniversary Edition of Tax Notes, Mark Weinberger authors a hilarious article titled, “Is This The Future of American Taxation?” One of his headlines is titled: Congress Abandons Alternative Minimum Tax Reform; Repeals Regular Tax. 

Funny through the tears

Many people are subject to the AMT. During the summer time, please contact the office and arrange an appointment if you were subject to AMT on your 2003 return or were near the AMT threshold. Sometimes (but not always) there are steps you can take to lessen the AMT. The office can only assist you if you take the time to meet and discuss your specific situation. Again, sometimes there is no help. For example, for regular tax purposes you can take a deduction for your children; they are your tax exemptions, but they are not deductible for AMT purposes. A while back, there was a court case where the family owed AMT only due to the presence of their 10 children! Clearly, there is no tax planning help at this stage! But AMT also kicks in by not allowing certain itemized deductions, such as taxes and miscellaneous itemized deductions. Sometimes the timing of payment across years can save you the AMT. But you must understand the threat that AMT imposes.

Can tax court help?

A recent court case points out the danger. In the Lauren Ostrow case the taxpayer was a tenant-stockholder in a cooperative housing corporation. Tenant-stockholders may deduct their proportionate share of real estate taxes paid by a cooperative housing corporation of which they are stockholders. Her share of real estate taxes paid by the cooperative housing corporation was $10,489 and she deducted $10,489 from adjusted gross income for regular tax purposes and in computing alternative minimum taxable income for alternative minimum tax purposes. The court held that the deduction does not reduce alternative minimum taxable income. In other words, the tax she paid on her home did save her income tax, but it increased her alternative minimum tax and she had to pay more tax! It seems so unfair, but the application of the statute is mechanical and the court frequently states as much.

What other possible remedies are there?

What can be done?  Perhaps she could time the payment of the real estate tax—perhaps some should be paid next year, not in the AMT prone year.  Sometimes nothing can be done except to recognize it and plan for the payment accordingly through estimated taxes.

According to Tax Analysts, a tax research organization, close to 6,500,000 taxpayers are subject to AMT right now.

AMT issues—please contact the office for help now.

Big Win For Long Term Care Residents

Recent rulings have helped further define what may be counted as a deductible medical expense. For example, the cost of teeth whitening does not constitute a deductible medical expense, and some medical supplies and equipment are not deductible if they were not prescribed by a physician.

The most recent battle on what is considered a deductible medical expense occurred in February 2004 in the Tax Court. The IRS had challenged an elderly couple on the type and amount of medical expenses they had claimed on their tax returns.

Is the cost of continuing care deductible as a medical expense?

The couple had moved into a retirement community that provided continuing care. They paid a monthly fee to reside in independent living quarters within the community. As residents they were allowed to move to an assisted-living area or to more advanced medical facilities if their health deteriorated. In case of emergencies, they had the use of a pull-cord alarm system within their unit.

The Tax Court ruled that a portion of their monthly fee qualified as a medical expense. The portion that is deductible is based on the percentage of the facility’s operating costs that qualify as medical expenses. These expenses include such items as skilled nursing, assisted living, and special care. It also included the use of the pull-cord system. The court required, and the taxpayers properly provided, a calculation which documented the portion of their monthly fee that was deductible as a medical expense.

Not all the claimed expenses were allowed

Some of the expenses that were denied included fees related to the pool, spa and exercise facilities. The IRS argued that these expenses were personal in nature and thus nondeductible. Expenditures “merely beneficial to the general health of an individual” are not deductible they argued.

The taxpayers provided a letter from their physician stating the necessity for the taxpayer to engage in a regular exercise program utilizing the exercise room, pool and spa facilities. They also provided a calculation for the allocation of a portion of their monthly fee to the use of the pool, spa and exercise room. The judge held that there was not sufficient documentation to establish the validity of the calculation, and accordingly, the amount of the deduction could not be substantiated, even if the expenses did directly relate to their medical care.

If you are unsure what portion or type of medical expenses are deductible, please contact the office for assistance. Together we can ensure that you are deducting the maximum amount allowable and that your documentation is sufficient to validate your deduction.

Real Estate Professionals

There are tax breaks for real estate professionals who are real pros. Qualifying as a real estate professional does not involve winning a contest or taking a course on buying property with no money down, but there are tax advantages for those who qualify. If you are considered a real estate professional you can treat losses and credits as active rather than passive. This can be significant since losses from non-passive activities are not limited like losses from passive activities.

If you want to qualify as a real estate pro in the eyes of the IRS, you must satisfy both of the following tests, and you must establish your “material participation.”

1. More than 50 percent of your personal services are performed in real estate businesses in which you materially participate.
2. You performed more than 750 hours of service annually in the real property businesses in which you materially participated.

Material participation defined

Material participation is defined in many ways and has other applications in the law aside from being a real estate professional IRS publications list seven different ways to satisfy the requirement. Any one of them is sufficient to establish material participation. They are summarized below.

1. You participated more than 500 hours per year in a single activity. (Note the 750 hour requirement above for real estate professionals. This requirement may be satisfied by participating in more than one activity.)
2. Your participation was substantially all the work involved in the activity.
3. Your participation in the activity included more than 100 hours and your participation in the activity was at least equal to anyone else’s.
4. Your total participation in “significant participation” activities exceeds 500 hours. (Significant participation activities are those in which you participated for more than 100 hours annually.)
5. Material participation in an activity for any five of the past ten years.
6. Material participation in a personal service activity for any three prior years. (Personal service activities are specifically defined and usually do not include real estate.)
7. Facts and circumstances show that you participated in the activity on a      regular, continuous, and substantial basis during the year.

Document your participation hours.

Substantiation of the hours spent is required to qualify as a real estate professional. Thus if you’re a landlord, developer, broker, etc., you should keep evidence such as calendar entries or a daily log of your hours as evidence of your hours of activity.

For those who can’t qualify as real estate professionals

Not all is lost if you fail to qualify as a real estate professional under the rules stated above. There is another tax break you may be able to take.

Up to $25,000 of losses from an actively managed rental real estate activity can be deducted against other income. Actively managed means you must exercise independent judgment in the conduct of the activity and not simply ratify the decisions of a manager or management company. There is no minimum number of hours you must spend to be actively managing, however this tax break phases out completely if your adjusted gross income exceeds $150,000.

Don’t be an amateur and miss out on these tax breaks. If you need help in determining whether or not you can qualify as a real estate professional please contact the office.

Update on Medical Expenses

If you itemize your deductions on Schedule A, medical expenses are deductible to the extent they exceed 7.5% of your adjusted gross income (AGI), which is the bottom line on page 1 of your income tax return. That threshold is a high one, but with the cost of health insurance and medical care escalating, a number of taxpayers do deduct medical expenses. Internal Revenue Code Section 213 allows medical expenses for:

the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body,

for transportation primarily for and essential to medical care

for qualified long-term care services, or

for insurance covering medical care or for any qualified long-term care insurance contract

 Recent tax court ruling

In a recent Tax Court case J. A. Alderman, a math teacher, is sight disabled and does not drive; hence his wife drives him to and from work, and drives extra mileage as a result, over and above the mileage she otherwise would have driven to get to and from her job. They deducted the extra mileage cost as transportation primarily for and essential to medical care.

The court had to deal with the question as to whether the transportation was primarily for and essential to medical care. The courts state that deductions are a matter of legislative grace and, if there is no sanction for the deduction, then none is allowed. In considering the possible deductibility of the expense in question the court considered both the provisions of Code Section 213, detailed above, and the provisions of Section 262(a) which preclude any deduction "for personal, living, or family expenses."

Is this “commute expense” deductible?

Commuting expense, the cost of driving to and from work, is not deductible. Period. Was this mileage deductible? The court said: No. Why? This Court has established a two-pronged, "but for" test in determining whether expenses were directly or proximately related to treatment of a medical condition: The taxpayer must prove that (1) the expenditures were an essential element of the treatment for the condition, and (2) the expenditures would not have otherwise been incurred for non-medical reasons.

Quoting an earlier case, Donnelly v. Commissioner, the court states: The taxpayer argues that braces and crutches are deductible as medical expenses and therefore the costs of his special automobile should also be deductible because he uses the latter as a substitute for the former. The petitioner's argument, however, ignores the fact that his automobile expenses, unlike the expense of braces and crutches, do not represent expenses incurred primarily for the alleviation of a physical defect or illness, which is a requirement for deductibility. 

The clinching argument is this: Even absent Mr. Alderman's sight disability, an identical scenario could have ensued if the spouses owned only one car.

Case closed

In other words, there is not a sufficient connection between the expense and medical treatment. Think of it this way: everyone needs transportation to and from work and that makes it a nondeductible, personal expense.

This is not to say that there are not many medical expenses, which are deductible. There are. But by studying court cases in which costs are not held to be deductible, we obtain a better grasp of what is deductible. Please speak with the office about all of your tax concerns. While the office can’t promise you’ll feel better, it will find a response for you.

FEBRUARY NEWSLETTER

--- Health Savings Accounts ---

The newest, hot test development out of Congress and signed by the President on December 8, 2003 is the Health Savings Account. This tax provision is found in the Medicare bill. This is an “improvement” on the Archer Medical Savings Accounts, which still do exist, but it seems clear that HSAs are “in” and MSAs are “out” in terms of popularity. What the Health Savings Accounts do is to allow an individual or family to purchase a high deductible health insurance policy and, since they have by definition shifted some of the risk of coverage to themselves by taking out a high deductible policy, they can put money into an IRA like account, into the Health Savings Account. The money they put in the account is TAX DEDUCTIBLE. When they incur medical costs which are not covered by insurance, the money that is taken out to pay for the medical expense is taken out TAX-FREE. In other words, the money that goes in is deductible like a Regular IRA, but it comes out tax free like a ROTH IRA. Wow Squared!

Can it be that good?

Details are just now coming out and the office doesn’t have all the final details, but enough to wet your appetite. The new Internal Revenue Code Section is 223 and it is so new that some tax research websites have not yet published it! (But the office does have access to it.) HSAs become effective in 2004; the benefits described below are not available for 2003.

On December 22, 2003 the Treasury Department released a good description of the benefits of the HSAs. The office has made some corrections to the Treasury Department release, which differ from the statute proper (in other words, the press release does not comport with the written statutory language, which we are legally obligated to follow!). In addition, voluminous detail can be found in an IRS Notice issued in early January. Some issues still remain unresolved, so expect future guidance.

Provisions of the plan

HSAs are similar to medical savings accounts (MSAs). However, MSA eligibility is restricted to employees of small businesses and the self-employed. HSAs are open to everyone under age 65 (those not entitled to benefits under Medicare) with a high deductible health insurance plan. The only limitation on the health plan is that the annual deductible must be at least $1,000 for individual coverage and at least $2,000 for family coverage. The sum of the annual deductible and the other annual out-of-pocket expenses required to be paid under the plan (other than for premiums) for covered benefits cannot exceed $5,000 for self-only coverage and $10,000 for family coverage. As you can see, the definition of high deductible is not outrageous. In fact, the cost of the high deductible plan should save you considerable premium dollars. That, coupled with the tax savings defined below, should help make medical insurance coverage much more affordable!

Contributions to the HSA by an employer are not included in the individual's taxable income. Contributions by an individual are tax deductible. Individuals, their employers, or both can contribute tax-deductible funds each year up to the amount of the policy's annual deductible, subject to a cap of $2,600 for individuals and $5,150 for families. Individuals aged 55-64 can make additional contributions. In 2004, an “older person” can contribute an additional $500 to the HSA. By 2009, an additional $1,000 can be added to the HSA. The cap mentioned cannot exceed the plan’s annual deductible for the specified self-only or family coverage.

 Will it save me money?

 If a family takes out a high deductible health plan with a deductible of $5,150, then they can fund ah HSA in the amount of $5,150 and take a deduction on page 1 of the 1040 in the amount of $5,150. If the family is in the federal 25% tax bracket, this deduction will save $1,288 in income tax.

 The interest and investment earnings generated by the account are also not taxable while in the HSA. Amounts distributed are not taxable as long as they are used to pay for qualified medical expenses, such as prescription and over-the-counter drugs and long-term care services as well as the purchase of continued health care coverage for the unemployed individual (via COBRA). The medical expenses paid qualify if paid for expenses of the account beneficiary, his or her spouse, or dependents. Amounts distributed which are not used to pay for qualified medical expenses will be taxable, plus an additional 10% tax will be applied in order to prevent the use of the HSA for non-medical purposes. The penalty will be avoided in case of distributions made after the account beneficiary’s death, disability, or attaining age 65.

 You can take it with you

HSAs are portable, so an individual is not dependent on a particular employer to enjoy the advantages of having an HSA. Like an individual retirement account (IRA), the HSA is owned by the individual, not the employer. If the individual changes jobs, the HSA goes with the individual.

 More details

The January IRS Notice referred to above includes a couple of other pertinent points. An individual does not fail to be eligible for an HSA merely because, in addition to a high deductible health plan, the individual has coverage for any benefit provided by "permitted insurance." Permitted insurance is insurance under which substantially all of the coverage provided relates to liabilities incurred under workers' compensation laws, tort liabilities, liabilities relating to ownership or use of property (e.g., automobile insurance), insurance for a specified disease or illness, and insurance that pays a fixed amount per day (or other period) of hospitalization.  

In addition to permitted insurance, an individual does not fail to be eligible for an HSA merely because, in addition to a high deductible health plan, the individual has coverage (whether provided through insurance or otherwise) for accidents, disability, dental care, vision care, or long-term care.  

Plan now for 2004

A self-insured medical reimbursement plan sponsored by an employer can be a high deductible health plan. If you operate a small business, please speak with the office about this possibility.

Expect to hear a lot about HSAs this year. And don’t be surprised if you find that an HSA makes sense for you. The office is here to help you on this and all of your other tax concerns.

 --- Taxing Your Winnings -- No Free Lunch ---

 “There’s no such thing as a free lunch.”

The origin of this quote is unclear but its meaning is hardly murky in the realm of taxes. Your “free” winnings, whether from a lottery, or from other gambling activities, entail the initial cost of your time, a minimum bet, or the purchase of a raffle ticket. There’s also a tax cost. Any cash winnings and the fair market value of non-cash winnings (e.g. shopping sprees, cars or vacations) are reportable income items that can be taxed as high as 35% on the federal level. Depending on your state of residence, your winnings could also be taxed at the highest state marginal tax rate.

When lottery winnings are taxed. 

Your winnings are reported in the year that you receive them. Thus, if you win the state lottery and elect to have it paid in a lump sum, you report the entire lump sum in the year you receive it. However if you choose to receive annual installments, the taxable amount is only the amount you receive each year. For example, if the payment is scheduled for December of the current year and instead you receive it in the following year, then you will not have to report the amount you received until the following year.

 Assign your winnings 

If you are participating in a pool to buy lottery tickets and the winnings are to be shared among the pool participants, it is important that the method for assigning the winnings be formally established before you actually win. Otherwise, if the winnings are in your name, you could be burdened with the entire tax payable on the winnings. In addition, If you fail to clearly establish how the winnings should be shared, you could be liable for a gift tax, depending on how much was given and to whom.

For example, if you and your colleagues equally contribute to a lottery pool and one of the tickets wins, each of you should report only his or her respective share of the winnings (assuming an agreement was in place on how the income would be shared). Note that the IRS can potentially question the validity of the sharing agreement, especially if it is shared with a family member.

Deduct Gambling Losses 

The only way to offset your gambling winnings is with gambling losses. Gambling losses are taken as an itemized deduction and are not subject to either the 2% floor or the 3% phase out for taxpayers with high adjusted gross income. If you are not eligible to itemize your deductions, you will not be able to deduct your gambling losses. If you are able to take this deduction, you are advised to provide documentary evidence (e.g. credit card statements, losing tickets, etc.) Note that the maximum loss deduction is the amount of gambling winnings. Any unused loss can be carried over to future years that also have gambling winnings.

Withholding and estimated tax on your winnings

Winnings (gross winnings less amounts wagered) are reported on Form W-2G by the payor. If your total winnings exceed $5,000, you are typically subject to a 27% federal tax withholding. If you fail to furnish your taxpayer identification number to the payor, you could be subject to a 30% withholding. In addition to federal withholding, some states require withholding which may also be summarized on your Form W-2G.

Your withholdings may not be enough to cover the total taxes due, depending on your federal tax bracket. Moreover you could be assessed an additional tax cost known as the underpayment penalty. This penalty applies when you do not pay enough taxes in advance during the year.

Consider estate tax issues

There are significant estate tax issues that may arise with gambling winnings. For example, if you win a large amount that is to be payable over a number of years and you die before all the installments are paid, your estate will have to report the present value of all future payments. This value is included in your estate and taxed as high as 49%. Careful tax planning can minimize your estate tax costs. 

The office can help you with all the planning recording, receiving and reporting issues related to gambling winnings and losses and can help you plan effectively to minimize estate taxes and make sure you have prepaid sufficient federal and state income taxes.

Disclaimer: This article is for general information purposes only, and is not intended to provide professional tax, legal, or financial advice. To determine how this or other information on this site might apply to your specific situation, contact the office for more details and counsel.  

January Newsletter

Calculating the Home Office Deduction

The November newsletter included a discussion of the requirements to qualify for a Home Office Deduction. This month's first article is a follow up to the November article. It gives practical help with the actual calculations involved in claiming the deduction. (This article was originally scheduled for inclusion in the December issue of the newsletter. However it was deferred to this month due to the importance and timeliness of the December article on yearend tax planning.)

 ---- Types of expenses which can be deducted ----

 Home office expenses can be divided into two types.

Direct expenses relate only to your office. These expenses include any repairs, interior decorating, carpeting, cabinetry, etc which are performed specifically on your office. They are 100% deductible as long as they benefit only your office.

 Indirect expenses relate to both your office and your home. These are general expenses, spent to run the entire home. They include such items as mortgage interest, property taxes, rent (if you do not own your home), property insurance, utilities, repairs which benefit your entire home, depreciation, etc. These expenses are partially deductible. The amount of the deduction is based on the size of your office in relation to the size of your home. 

---- Calculating your indirect expenses ----

Calculate the square footage of your office and the total square footage of your home. Divide the office square footage by the total square footage to compute the business use percentage. For example: suppose your office measures 10' X 20' (200 square feet), and the total area of your home is 2000 square feet. The business percentage is 10%. That means 10% of your total indirect expenses are deductible.

Some indirect expenses need to be adjusted before the business percentage can be applied. For example, electric bills include the cost of lighting, cooking, laundry, and television usage. Normally the latter three expenses are not part of running your office. Only lighting would be a shared expense of the office and the residence. An allocation of the electric bills needs to be made between lighting and those activities which are not related to the office. Suppose electricity costs $1,200 per year, and it is determined that 30% is a reasonable allocation to lighting expense. Assuming that the office business percentage as determined above is 10%, your deduction for electricity will be limited to $36.(30% of $1200 = $360, and 10% of $360 = $36.)

---- A Comprehensive Example ----

Let's apply these principles to the following situation:

The office portion of Shelley's home is 10%. She has the following expenses this year for her home: Mortgage interest $12,000

Property tax $3,500

Property insurance $900

Security $300

Utilities $1,200; only $360 is for lighting

General Repairs $1,000

Specific repairs to the office $150

Depreciation $12,000

Landscape Maintenance $500

Office sign $100

Shelly's home office deduction is calculated as follows. Indirect expenses include: (the mortgage interest deduction of$12,000, property tax $3,500, property insurance $900, security $300, utilities $360 (based on the calculation above), general repairs $1,000, depreciation $12,000) and landscape maintenance $500.00. The indirect expenses total $30,560.00. Multiplying this total by the office use percentage of 10% gives Shelley a deduction for indirect expenses of $3,056;

Shelly's only direct expenses are the repair made in her office and the office sign. These expenses total $250 and are 100% deductible.

The direct expenses and the deductible portion of the indirect expenses are combined to give Shelly a home office deduction of $3,306 for the year.

---- Take action ----

For more information on home office deductions you can refer to Form 8829 and the instructions for the form. To discuss your specific situation compile the relevant expenses and do the necessary, square footage calculations. Then contact the office, and arrange a time when we can discuss the estimates and allocations necessary to make sure you are maximizing your home office deduction.

Shopping Bags and Shoe Boxes

Most tax preparers can relate stories of tax clients who bring in their tax records every year, stuffed into a shoe box or a shopping bag, with no organization at all. Sometimes these clients expect their preparer to ask them questions and they in turn will dig through the multitude of documents to find the answers. In other cases they expect to leave the box or the bag for the preparer to sort and extract the pertinent information. This is definitely not the best way to get information to your tax preparer.

--- Save money ---

Preparers charge significantly more for a return where they must search through source documents for the information. Now is the time to organize your documents and begin to fill out that tax organizer.  A few hours of your time invested in filling out the organizer before your tax appointment should reduce your tax preparation fee, and it will also provide two other benefits for you:

 1. A careful and thorough completion of the organizer will help assure that you do not miss deductions, credits or other tax benefits which are rightfully yours. This can also result in more money in your pocket.

 2. You will gain a better understanding of what is included on the    return and how it goes together.

--- Your responsibility ---

Remember that your signature on the return is placed under the following statement: “Under penalty of perjury I declare that I have examined this return and accompanying schedules and statements, and to the best of my knowledge and belief, they are true, correct, and complete.” Filling out the organizer will help provide the knowledge of the return you should have.

The Military Family Tax Relief Act (P.L. 108-121)

In November we paid tribute to members of the armed forces on Veteran’s Day. On that very same day, President Bush signed into law the Military Family Tax Relief Act of 2003. While this law does not affect all taxpayers, it will have a significant effect on those who do qualify. The law extends benefits in several different areas. Following is a summary of its provisions.

--- Special rules for sale of residence ---

The general provisions of the current tax law provide that at least a portion of the gain from the sale of a principal residence shall not be included in gross income if, during the 5-year period ending on the date of the sale or exchange, the residence has been owned and used by the taxpayer as the taxpayer's principal residence for periods totaling 2 years or more. The amount of gain that is tax-free is up to $500,000 for a married couple filing joint, and up to $250,000 for a single taxpayer.

The new law provides that, for members of uniformed services and foreign service, the running of the 5-year period shall be suspended during any period that the individual or his or her spouse is serving on qualified official extended duty. The law allows the 5-year period to be extended up to 10 years. Look at the following example of how this new law might be helpful.  Suppose a qualifying service person has purchased a residence and, after living in it for one year, is transferred to another location. Under the general law, if the individual returned four years later and wanted to sell the residence, he or she would fail the two years out of five years test and would not be able to exclude the gain. The new law extends the five year period up to ten years. Following are some necessary definitions. The term "qualified official extended duty" means any extended duty while serving at a duty station which is at least 50 miles from the residence in question or while residing under Government orders in Government quarters. The term "extended duty" means any period of active duty pursuant to a call or order to such duty for a period in excess of 90 days or for an indefinite period. The benefits of this section are retroactive, going back to the Taxpayer Relief Act of 1997. Amendments will even be allowed for closed years if the taxpayer adheres to the time frame specified in the law.

--- Benefit increase ---

The office sincerely hopes that this next provision will never apply to any of its clients or their friends or families. The amount of the “death gratuity” (the term used by Congress) is increased to $12,000. This change is effective as of September 11, 2001 , and the amount is totally tax-free.

--- Base realignment and closure fringe payments ---

Qualified military base realignment and closure fringe payments are tax free under the same Code Section 132 that provides for tax free fringe benefits. The act defines these payments in rather technical terms. If you think you may qualify for these tax free benefits, please call the office for help in interpreting the definitions. This change in the law was enacted to offset the adverse effects on housing values as a result of a military base realignment or closure.

--- Extension of time for tax filings ---

The current law provides that the time for performing certain acts (such as the filing of tax returns) is postponed by reason of service in a combat zone. This provision is expanded to cover “contingency operations”. This applies when deployed outside the United States away from the individual's permanent duty station while participating in an operation designated by the Secretary of Defense as a contingency operation. This term also is defined in a technical manner. The office can help you determine if you qualify.

--- Significant provisions for unique circumstances ---

Dependent care assistance programs are defined as being tax-free.

 A distribution from a Coverdell Educational Savings Account is not subject to a 10% penalty if the distribution is made on account of the attendance of the designated beneficiary at the United States Military Academy, the United States Naval Academy, the United States Air Force Academy, the United States Coast Guard Academy, or the United States Merchant Marine Academy, to the extent that the amount of the payment or distribution does not exceed the costs of advanced education (as defined in title 10, of the United States Code).

The law suspends the tax-exempt status of terrorist organizations. 

Tax relief and assistance is provided for the families of the “Space Shuttle Columbia Heroes”.

--- Overnight travel for national guard and reserve members ---

Of more general interest is Section 109 of the Act which allows an above-the-line deduction for overnight travel expenses of National Guard and Reserve Members. Quite simply, if the taxpayer is more than 100 miles away from home in connection with such services, a deduction is allowed for the travel expenses on page one of the 1040 tax return. The deduction taken can include per diem in lieu of subsistence. This is effective for the 2003 tax year. As such, if you performed services as a member of a reserve component of the Armed Forces of the United States and you were more than 100 miles away from home when you performed those services, you have a brand new deduction coming your way. Make sure you track your travel expenses and your time away from home for this purpose.

 --- Funding ---

 This tax bill is not funded by any new tax increases; rather it is funded by the extension of customs user fees.

 And as always, thank you to all the men and women who help to protect our country and who enable us to live in freedom!

DECEMBER NEWSLETTER 

     * Year-end Tax Planning
     * The Military Family Tax Relief Act (P.L. 108-121)

 --- Year-end Tax Planning ---

Now is the time for you to review your year-end tax situation and see if there are strategies you can employ to lower your taxes. The general tax strategy is to accelerate losses, expenses and deductions so as to recognize them this year and defer income into later years. Listed below are a few of the specific actions which implement the general principles. You will probably not be able to take advantage of all of them, so study each one carefully to see if it could apply to your situation and help reduce your year-end tax burden.

·         Minimize your capital gains.
If at year-end you have a net capital gain, disposition of securities at a loss will offset this gain. If your losses exceed your gains, the maximum capital loss deduction is $3,000. Any remaining losses can be carried to later years.

·         Are you eligible to itemize deductions?
Make sure that you are eligible to itemize deductions in the current year. If you can't itemize, those strategies listed below which rely on increasing the itemized deductions will not provide any benefit to you.

·         Donating appreciated stock to a charity.
The main benefit of donating appreciated stock that has been held for more than one year, is that you can take a deduction for its appreciated value without paying tax on its appreciation. Thus you obtain a deduction that is greater than what you paid for the stock. 

·         Prepay your state and local taxes.
If you believe you will owe state and/or local taxes when you file your returns but do not expect to owe Alternative Minimum Tax, you can increase your federal deductions by prepaying the state and local taxes before the end of this year.

·         Accelerate payment of your interest expense.
Pay your January mortgage payment before the end of December to take advantage of the interest deduction in the current year. If you have refinanced your home, you can write off the balance of points that remained from an earlier refinancing.

·         Accelerate your property tax payments.
The property tax due on your home is usually divided into two installments. Typically one installment will be due this year and the second installment due next year. If you will not be subject to Alternative Minimum Tax you may benefit by paying both installments before the end of this year.

·         Evaluate those itemized deductions subject to AGI limitations.
There are a number of deductions that can be limited by your adjusted gross income (AGI) level. For example medical expenses can be deducted only for the portion that exceeds 7.5% of your AGI. Miscellaneous expenses such as IRA fees, tax preparation fees, investment assistance, safe deposit fees and unreimbursed employee business expenses are subject to the 2% of AGI limit. Thus you should evaluate your projected AGI level for the current year to see if you should accelerate your deductions. If you expect your AGI to drop considerably next year, you may want to defer your expenses so that they are not lost because of the higher AGI this year.

·         Flex your credit card.
You can leverage deductions off your credit card by charging deductible expenses in the current year and postponing payment on them until the following year. The expenses are deductible in the year they are charged. Deductible expenses which can be charged include medical expenses, charitable contributions, business expenses, and, in many states, your state income taxes. Of course delaying payment indefinitely on these charges is not recommended since the interest expense can outweigh the tax benefit.

·         Section 179 - new limitations.
Up to $100,000 in business assets can be expensed for federal tax purposes if qualified assets are placed in service by year-end. The phase-out threshold starts at $400,000. If you purchase more than $100,000 of assets in the current year, expense the assets with longer lives. This approach allows you to maximize your deductions and remaining write-offs.

·         Keep one eye on your AGI.
There are many tax deductions and credits that are phased out when your AGI exceeds certain limits. Some of those deductions and credits are listed below.

* The Child Tax Credit
* The education (both Hope and Lifetime) credits
* Traditional IRA contributions
* The student loan interest deduction
* The new tuition deduction
* Reduction of allowable itemized deductions
* The Earned Income Credit
* Deductible medical expenses
* Allowable miscellaneous itemized deductions
* Passive rental loss deductions (the $25,000 exception)
* Taxation of Social Security benefits

It would be lovely if all of the phase-out amounts were consistent, but that is not the case. They are different for each separate deduction and/or credit. If there is a deduction or credit you plan to claim on your return, be sure you are aware of the AGI threshold and the effect of these phase outs. Some of the techniques listed above may help you reduce your AGI and maximize your credits and deductions.

Keep your other eye on the AMT.
More and more taxpayers are being required to pay the dreaded alternative minimum tax (AMT). This is a completely separate tax, with different rules for its calculation. You compare your normal tax to your AMT and pay the greater of the two. It's not much of an alternative, but it's one to be aware of. The IRS computers can catch this tax if it is overlooked on your return. You could be subject to the AMT If you have any of the following: a large number of personal exemptions; large amounts of state and local taxes paid; large amounts of miscellaneous itemized deductions; large deductible medical expenses; the bargain element of incentive stock options (ISOs); and/or large capital gains. Planning for the AMT is even more difficult than planning for your normal taxes because each situation is unique. If you see yourself in the AMT zone, make sure that you understand the impact on your bottom line. The potential of AMT is a very good reason for a consultation in the office before the end of the year. Even if you can't do anything to reduce your AMT, at least know it's there so you won't make any year-end moves that would make matters worse.

If you need assistance in your year-end tax planning, please contact the office as soon as possible. Often there are subtleties in these techniques which may apply to your situation. Don't put off these decisions to the last minute and get caught in the year-end press to get things done.

                                                The Military Family Tax Relief Act (P.L. 108-121) ---

In November we paid tribute to members of the armed forces on Veteran's Day. On that very same day, President Bush signed into law the Military Family Tax Relief Act of 2003. While this law does not affect all taxpayers, it will have a significant effect on those who do qualify. The law extends benefits in several different areas. It seems appropriate to summarize its provisions as we have just honored the memory of those who have died in the protection of our freedoms.

The general provisions of the current tax law provide that at least a portion of the gain from the sale of a principal residence shall not be included in gross income if, during the 5-year period ending on the date of the sale or exchange, the residence has been owned and used by the taxpayer as the taxpayer's principal residence for periods totaling 2 years or more. The amount of gain that is tax-free is up to $500,000 for a married filing joint couple, and up to $250,000 for a single taxpayer.

The new law provides that, for members of uniformed services and foreign service, the running of the 5-year period shall be suspended during any period that the individual or his or her spouse is serving on qualified official extended duty. The law allows the 5-year period to be extended up to 10 years. Look at the following example of how this new law might be helpful. Suppose a qualifying service person has purchased a residence and, after living in it for one year, is transferred to another location. Under the general law, if the individual returned four years later and wanted to sell the residence, he or she would fail the two years out of five years test and would not be able to exclude the gain. The new law extends the five year period up to ten years. Following are some necessary definitions. The term "qualified official extended duty" means any extended duty while serving at a duty station which is at least 50 miles from the residence in question or while residing under Government orders in Government quarters. The term "extended duty" means any period of active duty pursuant to a call or order to such duty for a period in excess of 90 days or for an indefinite period. The benefits of this section are retroactive, going back to the Taxpayer Relief Act of 1997. Amendments will even be allowed for closed years if the taxpayer adheres to the time frame specified in the law.

The office sincerely hopes that this next provision will never apply to any of its clients or their friends or families. The amount of the "death gratuity" (the term used by Congress) is increased to $12,000. This change is effective as of September 11, 2001, and the amount is totally tax-free.

Qualified military base realignment and closure fringe payments are tax free under the same Code Section 132 that provides for tax free fringe benefits. The act defines these payments in rather technical terms. If you think you may qualify for these tax free benefits, please call the office for help in interpreting the definitions. This change in the law was enacted to offset the adverse effects on housing values as a result of a military base realignment or closure.

The current law provides that the time for performing certain acts (such as the filing of tax returns) is postponed by reason of service in a combat zone. This provision is expanded to cover "contingency operations". This applies when deployed outside the United States away from the individual's permanent duty station while participating in an operation designated by the Secretary of Defense as a contingency operation. This term also is defined in a technical manner. The office can help you determine if you qualify.

Dependent care assistance programs are defined as being tax-free.

A distribution from a Coverdell Educational Savings Account is not subject to a 10% penalty if the distribution is made on account of the attendance of the designated beneficiary at the United States Military Academy, the United States Naval Academy, the United States Air Force Academy, the United States Coast Guard Academy, or the United States Merchant Marine Academy, to the extent that the amount of the payment or distribution does not exceed the costs of advanced education (as defined in title 10, of the United States Code).

The law suspends the tax-exempt status of terrorist organizations.

Tax relief and assistance is provided for the families of the "Space Shuttle Columbia Heroes".

Of more general interest is Section 109 of the Act which allows an above-the-line deduction for overnight travel expenses of National Guard and Reserve Members. Quite simply, if the taxpayer is more than 100 miles away from home in connection with such services, a deduction is allowed for the travel expenses on page one of the 1040 tax return. The deduction taken can include per diem in lieu of subsistence. This is effective for the 2003 tax year. As such, if you performed services as a member of a reserve component of the Armed Forces of the United States and you were more than 100 miles away from home when you performed those services, you have a brand new deduction coming your way. Make sure you track your travel expenses and your time away from home for this purpose.

This tax bill is not funded by any new tax increases; rather it is funded by the extension of customs user fees.

And as always, thank you to all the men and women who help to protect our country and who enable us to live in freedom!  

NOVEMBER 2003 NEWSLETTER

 * Welcome to the Space Age

 * Home Office Deduction -- Who Qualifies?

 * The Music Man

--- Welcome to the Space Age ---

The IRS has announced that, effective October 1, 2003 , they will accept many documents by fax. This may seem like a small change, but it is not. Previously, many forms had to be mailed to the IRS and many times that entails several days. Not only that, but mailings can be lost and never arrive at the IRS office. The number of forms that can be faxed is very impressive; several of these forms deal with IRS controversies, that is, IRS collection matters, but not all the forms are controversy forms. Let's look at the details of this document titled: Use of Faxes for Taxpayer Submissions.

While the primary communication methods for these contacts have traditionally been mail, phone or personal interviews, the IRS is always seeking new ways of communicating with taxpayers that will reduce taxpayer burden and improve organizational efficiency. Based on requests from practitioners and other outside stakeholders, the IRS has adopted the following guidance on the acceptance of faxes by taxpayers and the practitioner community.

Some of you might be asking: Will the IRS soon permit communication of several forms over the Internet? The answer is: Yes--this is in the works and might premiere this year, though that now seems doubtful. If it took the IRS THIS long to allow faxes, you have to wonder how soon the promised internet/e-mail communication will become effective. (But we may be surprised soon!)

There are restrictions on what can be faxed: Filing of original tax returns via fax will only be allowed as part of a return perfection process (e.g. securing a missing schedule or missing signature) initiated by the IRS or in certain post-filing/non-filing activities. Tax returns can be received via fax as part of return perfection, even if a taxpayer signature is required, provided that IRS contact with the taxpayer has been made and documented.

The following items CANNOT be faxed:

* Employee Plan and Exempt Organization determination letter applications will not be accepted via fax.
* Determination Letter Requests related to income tax, gift tax, estate tax, generation-skipping transfer tax, employment tax and excise tax matters will not be accepted via fax.
* Consents to extend the statute of limitations for assessing tax (Form 872, SS-10, and other consent forms) will not be accepted via fax in normal operations.

But look at what CAN be faxed all the time. The following specific documents/forms/letters will continue to be accepted by fax in routine operations:

* EIN Requests (Form SS-4)
* Power-of-Attorney (Form 2848)
* Taxpayer Authorization (Form 8821)
* 1120S Election (Form 2553)
* Return/Transcript Requests (Form 4506)
* Request for Public Inspection or Copy of Exempt or Political Organization IRS Form (Form 4506-A)
* Foreign Certification Requests
* Appeals Conference Requests
* Responses/documentation needed to resolve filing or post-filing questions or correspondence.

The following CAN be faxed after contact with the IRS. The following specific documents/forms/letters can be accepted by fax if contact has been made with the taxpayer by phone or in-person, and the taxpayer history file is documented with the date of contact, and notation is made that the taxpayer wishes to send the document/form/letter by fax:

* Requests for Innocent Spouse Relief (Form 8857)
* Taxpayer Statement About a Refund (Form 3911)
* Injured Spouse Claim (Form 8379)
* Installment Agreements (Form 433-D)
* Collection Information Statement - Wage Earner (Form 433-A)
* Collection Information Statement - Business (Form 433-B)
* Early Referral Requests Fast Track Mediation Requests
* Request for Collection Due Process Hearing (Form 12153)
* Letter to designate a payment
* Letter to request non-filing of lien
* Letter to request lien release
* Letter to request lien withdrawal
* Letter to request non-assertion of penalty
* Letter to provide reasonable cause statement
* Supporting Statement to Correct Information (Form 941C)
* Election by a Small Business Corporation (Form 2553)

As always, contact the office as soon as possible with any tax concerns. The earlier the request for help is submitted, the better. But submission by fax is major, and the Internet cannot be far behind! The IRS IS catching up with the future!

--- Home Office Deduction -- Who Qualifies? ---

In general, the tax provisions do not allow deductions for personal expenses such as interest on your credit cards or losses on the sale of your principal residence. However the IRS does allow a deduction for part of your home--if it is used for business.

To qualify for a deduction of a portion of your home expenses you must meet the following requirements:

* You exclusively use a certain part of your home on a regular basis as your principal place of business, or
* You exclusively and regularly use a certain portion of your home as a place of business for meeting or dealing with patients, clients, or customers in the normal course of your business, or
* You exclusively and regularly use a separate and detached part of your home in connection with your enterprise.

Convenience of your employer

If you are an employee, and wish to take an Office in Home deduction you need to fulfill one other requirement. Your home office must be used for the convenience of your employer. Let's see some examples.

If your employer is in Virginia and has employed you to build sales in California , it will be impractical for you to have your office in Virginia . Thus, maintaining an office in your home will be for the convenience of your employer. However, if you are a journalist and your employer provides an office for you, but you find it more convenient to work at home rather than making a trip to the office, the IRS will most likely frown upon any home office deduction since the home office is for your convenience rather than the employer's.

Exclusive and regular use

Whether you are self-employed or an employee, your qualification for a home office deduction requires regular and exclusive business use.

Regular use means that the area you use for business is not used sporadically or occasionally. Even though that area in your basement is used only for business, you cannot claim a home office deduction unless it is used on a continuing basis.

Exclusive use means that the area you use for your home office is used only for business. This means that you or other members of your family cannot use the area you have designated as your home office for purposes other than business. It also means that you cannot work on your laptop in various rooms of your home and claim such use as a home office. You must have a designated space which you use for business purposes only. There are two exceptions to the "exclusive use" rule. These exceptions apply to wholesale or retail sellers who need to store inventory and to licensed day care operators. The exceptions are not discussed in this article.

Do you think you have met all the tests to take a home office deduction? Even if you qualify under all the tests outlined above, you may still not be able to take the deduction. There is a rule that prohibits you from deducting home office expenses if your business already operates at a loss. Expenses disallowed under this rule may be carried to future years and used when the business is showing a profit.

Example: Your total gross revenue is $10,000 for designing websites. Business expenses such as advertising, software and travel amount to $11,000. Even though you may have otherwise qualified for the home office deduction, you won't be able to take the deduction since your business is already operating at a loss.

As you can see, the requirements for taking the home office deduction are very strict. The Taxpayer Relief Act of 1997 helped to clarify whether or not your home office is your principal place of business. A principal place of business exists if the following conditions are met:

* The space is used exclusively and regularly for administrative or management activities for the business, and
* There are no other fixed locations of the business to conduct these activities.

Administrative or management activities can include billing clients, bookkeeping, and arranging appointments. Often these activities may be done in various locations that are not fixed. Locations such as a hotel room, a car or a client's office may be very common for those who work in sales. Under the 1997 Act, you can meet the "principal place of business" requirement if there is not another, fixed location to conduct your activities aside from your home office.

Selling your residence

In December 2002 regulations were finalized on the treatment of the sale of a primary residence that includes a home office. If the home office is separated from the residence, you must allocate the sale price between the residence and office portions and report the sale of the office in home as a separate sale.

Example. Buffy owns a 3-story townhouse which has a basement with its own entrance, plumbing and electrical wiring, so that it is separate from her personal residence. Buffy uses the basement as her home office. Upon the sale of the townhouse, Buffy must allocate the sale price between the personal and business portions of the property, and report the gain (if any) on the sale of the business portion as a separate sale. If the home office is located within the residence, any gain on the sale of the home is excludible under the home exclusion rules (except for the depreciation taken after May 6, 1997 ).

Example. Frank uses a spare room in his house as a law office. He meets the home office deduction requirements and has accumulated depreciation of $2,000 when the house is sold. The gain on the sale of the house is $20,000. Frank does not have to allocate the gain to his home office, however he must report at minimum, $2,000 gain which is the recapture of his prior year depreciation deductions.

If you have questions regarding your ability to qualify for a home office deduction, now would be a good time to let the office help you make the determination. This will give you adequate time to make the necessary calculations before the tax filing season

Next month's newsletter will discuss the actual mechanics of calculating the home office deduction.

--- The Music Man ---

Remember the wonderful musical by Meredith Wilson, in which the townspeople, awaiting the imminent arrival of the instruments for the boys' band, sang, "The Wells Fargo Wagon Is Coming To Town". Everybody likes to get something delivered to them, and while the Wells Fargo Wagon makes no further stops in our town, we do have the modern day equivalent, FedEx. This month's piece on tax deals with the recent district court decision involving FedEx.

The case is fairly simple. It arose from a dispute about the tax treatment of FedEx's off-wing engine maintenance program during 1993-1994. The IRS argued that these costs should be capitalized. FedEx argued that these costs were currently deductible as maintenance costs.

The tax law differentiates between expenses which are currently deductible because they are ordinary and necessary repairs and/or maintenance, and expenses which must be capitalized and which costs must be recovered over a span of years. Obviously, most taxpayers want to take a deduction for costs incurred during the year they are incurred. Many of you know, from reading the articles, that Congress has increased Section 179 which allows a taxpayer to deduct up to $100,000 of capitalizeable costs, that is, generally, a taxpayer can take a current deduction for the cost of an asset, such as technology equipment using Section 179. Still, the issue of repair vs. capital expenditure is important since repairs are deductible without taking into account any special Code election.

Section 162 allows taxpayers to deduct ordinary and necessary business expenses paid or incurred during the current taxable year. Treasury Regulation subsection 1.162-4 implements Section162, and provides the following guidance: "The cost of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinary efficient operating condition, may be deducted as an expense." Treasury Regulations further provide that items are capital expenditures if they "(1) . . . add to the value, or substantially prolong the useful life, of property owned by the taxpayer . . . or (2) . . . adapt property to a new or different use." The Capitalization Regulation further provides that "amounts paid or incurred for incidental repairs and maintenance of property are not capital expenditures."

It is often not easy to decide whether an item should be capitalized or expensed. The courts have commented on this in various court decisions. Following are some examples: "The distinction between capital expenditures and ordinary and necessary business expenses evades easy description." Dominion Res., Inc. v. United States . "Some items are clearly capital and other items are clearly expense, but between the two extremes a point is approached at which it is difficult to determine whether the expenditure is capital or an expense." Libby & Blouin, Ltd. v. Comm'r. "Whether a business expense is capital is highly dependent on the particular circumstances of a given case and is ultimately a factual determination for the trial court." United Dairy Farmers, Inc. v. United States .

In the FedEx case the court sided with FedEX and allowed the current deduction of the ESV (Engine Shop Visit) expenses as normal maintenance.  The court drew the following conclusions:
  1. The ESVs  at issue in this case did not adapt any of FedEx's
     aircraft engines to a new or different use.
  2. The ESVs at issue in this case did not materially increase
     the value of FedEx's aircraft engines.
  3. The ESVs at issue in this case did not appreciably prolong the
     lives of FedEx's aircraft engines, but merely maintained them
     in proper working order during their expected useful lives.

 "Whether a business expense is capital is highly dependent on the particular circumstances of a given case and is ultimately a factual determination." Let the office help you make that determination, and may all your deliveries from FedEx be items that bring you pleasure and comfort.

OCTOBER NEWSLETTER 2003

* Exceptions
* Beware

 --- Exceptions ---

The law is the law, like it or not. The law is the law - except.

Tax law is contained in Title 26 of the United States Code and contains a whole bunch of statutes. Sometimes the law is clear-cut. But even when it is, there are many exceptions built into the law. It is the office's job to help you comply with the law. Sometimes that help entails research to see if an exception applies to you. One situation where the office will search for exceptions involves penalties or tax "charges" for certain transactions. This is made clear in the recent court case of Mary L. Coleman-Stephens v. Commissioner. (The text of this case is available at www.ustaxcourt.gov.)

Many court cases are, at their core, quite simple. Here is what happened. Ms. Coleman-Stephens worked for the Post Office. Some time back she received a loan from the Federal Employees' Thrift Savings Plan (TSP). The loan was not repaid or reamortized by the required deadline. Consequently, the TSP National Finance Center declared that she had a taxable distribution from the plan in July 1999 in the amount of roughly $5,000, the amount of unpaid principal and interest as of July 1999.

This amount is taxable and was properly included on the return. However, she did not include the 10% penalty for early withdrawal. The IRS went after her for a penalty of $500.

But, there are exceptions for the penalty, including one for disability. The statute provides the meaning of disabled:

"For purposes of this section, an individual shall be considered to be disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration. An individual shall not be considered to be disabled unless he furnishes proof of the existence thereof in such form and manner as the Secretary may require."

The court determined that she did meet this definition. Expert testimony from her psychologist revealed that:

At the present time, however, there remain significant depressive symptoms and behaviors and a return to work is not recommended.

In summary, Ms. Coleman-Stephens' attempt to return to work in June of 1998 resulted in an exacerbation of her depressive illness to the point where she was unable to work. Further, she has been disabled since then and remains so at this time, though with progress noted and fair prospects for eventual return to work in some capacity.

The court found that her "disability was indefinite at the time of the TSP distribution. At that time, petitioner had attempted to return to work, which only caused her condition to worsen. She was unable to work due to her disability, and there was no reasonably certain indication of when she would be able to return to work. Indeed, as of the time of trial petitioner had been unable to do so. The inability to predict when, if ever, petitioner would be able to return to work caused the disability to be indefinite within the meaning of section 72(m)(7) and section 1.72-17A(f)(3), Income Tax Regs."

Bottom line: She did not have to pay the $500 extra tax. The office will work with you to look for the exceptions and to save you all tax dollars to which you are legally entitled. Just like the Post Office, neither sleet, nor snow, nor hail will keep the office from helping you!

--- Beware ---

The advice to embrace change is not always good advice. The advice to judge change and plan for it judiciously is always good advice. And it is with this in mind that this article addresses an important topic: choice (or change) of business entity. With the recent change in tax law, some businesses that used to be what are called C Corporations might want to become S Corporations. Some S Corporations might want to become C Corporations, to take advantage of the 15% rate on dividends and potentially lower rates in C Corporations. If the law changes later, some present C Corporations might want to become S Corporations. Beware.

When a C Corporation changes to an S Corporation, a tax may be levied over the next 10 years on the S Corporation. Understand that while a C Corporation pays tax, an S Corporation does not pay tax. An S Corporation is a flow through entity like a partnership, with the incidence of taxation taking place at the shareholder level, which is on the 1040. There is an exception to an S Corporation not paying corporate level tax; if the C Corporation converts to an S Corporation, and there is disposition of any assets over the next 10 years, then there will be tax to the extent of built in gain. What is built in gain? At the date of conversion from C to S, the balance sheet is reviewed. If the fair market value of the assets on the balance sheet exceeds the tax basis of the assets, then there is appreciation; there is potential built in gain. If these assets are disposed of over the next 10 years, then a corporate level tax will be assessed. There are ways to minimize the tax. First and foremost, an accurate appraisal must be made, and the assets must be valued, to insure the proper fair market value. Second, if there is potential built in gain, the taxation can be avoided if the taxable income of the S Corporation is zero for each of the next ten years. This can be achieved by payment of compensation and proper expense planning. But there is more: a recent IRS Letter Ruling, number 200329011, deals with a personal injury law firm, which enters into contingent fee agreements. The issue is whether pending law suits, which were not yet resolved at time of converting from C to S, would be items of built in gains.

If a physician converts from a C Corporation to an S Corporation, the receivables, which the cash basis physician has, are items of built in gain and when collected within the S Corporation will trigger a built in gain tax at the S Corporation level. As such, a physician should move with great care from a C to an S. In the above referenced Letter Ruling, the IRS held that the revenue from the legal work which was contingent upon the outcome of the cases that were still open at the time of conversion, would not be items of built in gains since the income would not have been properly included in the gross income of an accrual method taxpayer prior to the settlement of the cases.

In other words, the law firm could switch from C to S without any impact on built in gains tax since the fees were under a contingency fee arrangement and the cases had not been resolved and thus the income was not earned prior to conversion.

This is good news for legal firms. For other professionals, watch out. Please work closely with the office if you are reevaluating your choice of business entity. 

September Newsletter

·         Difficult Economic Times

·         Writing Off Your Trip to the IRS

·         Tax Deductible and More

·         So You Got a Part Time Job?

 **** Difficult Economic Times ****

 The office hopes that everyone is doing well economically, but sometimes life throws out curves and we all have difficult times. Even the IRS understands this.  They have recently released an informative publication, titled Tax Impact of Job Loss, Publication 4128, available at www.irs.gov or www.irs.gov/formspubs which is a site that will take you directly to the IRS Forms and Publications page.

The publication correctly states that job loss creates tax issues. Absolutely true.  Many things in life have tax consequences. 

The Publication has four main tax points: Job Loss--What Income is Taxable, Pensions/IRA's--What's Next, Starting Your Own Business, and Miscellaneous Tax Information. 

Let's start with What Income is Taxable. The following payments are taxable: Severance, Accumulated Leave or Vacation Pay and Sick Pay, and Unemployment Compensation. Gifts of Cash and Property from Family and Friends and Public Assistance or Food Stamps are not taxable. 

 Pensions/IRA's--What's Next. Be careful about withdrawing money from a qualified retirement plan or IRA. If done before eligible age and not rolled over into another qualified retirement plan or IRA within 60 days, not only will it be taxable, but you will also have to pay an additional 10% tax on the early distributions. There are exceptions, but don't expect them to apply. 

Starting Your Own Business: Sometimes loss of a job prompts us to start our own business. The office can help you start a business successfully. Should you be a sole proprietor, or a Limited Liability Company, or an S or C Corporation?  There is no short answer to this question, but the question should be asked. If you do start your own sole proprietorship, the office will be available to explain to you all there is to know about self employment tax and estimated taxes. These taxes might be new to you, so call the office to arrange an appointment so you are not surprised by these requirements.

Miscellaneous Tax Information: Job seeking expenses are deductible if you look for a new job in your present occupation, even if you do not get a new job.  These expenses are deductible only as a miscellaneous itemized deduction, and only to the extent the total amount of miscellaneous itemized deductions exceeds 2% of the Adjusted Gross Income (AGI). The IRS provides some examples of these expenses, and they include employment and outplacement agency fees for work in your occupation. You can also deduct amounts for typing, printing and mailing copies of your resume to prospective employers. Also be sure to track travel costs, including away from home costs, for interviews or job hunting. If you move more then 50 miles for a new job, then you can deduct moving expenses.  Education costs may also be deductible. They might be deductible as a Hope or Lifetime Learning Credit, or as a business expense, or as a Section 222 deduction on page 1 of the tax return. If you take any education courses, job related or not, speak to the office about them. There is a good chance there is an Internal Revenue Code Section that might provide benefit. 

A job loss is always tough. Changing courses always presents challenges.  Everything has a tax impact. Let the office work with you to get the benefit from the tax law that Congress intends for you to have. And keep your positive attitude--the future is bright!

 **** Writing Off Your Trip to the IRS ****

Have you made a trip to an IRS office for an audit? The mileage to and from the audit is deductible according to a recent ruling by the Tax Court (Stussy v. Commissioner), filed August 4, 2003 . In addition to the mileage to and from the audit, the Court also allowed other mileage related to the determination of tax. This is true even though the mileage was in settlement of a personal tax audit.

The general rule is that a taxpayer can deduct business auto expenses under one of two methods. The first method is to substantiate your car expenses by keeping records of amounts paid for gasoline, insurance, repairs and other costs.  Only a business percentage of these actual costs can be deducted.

The second method is the standard mileage rate method which is much simpler than the first method. You do not have to keep records of any car expenses. For Year 2003, the deductible portion under this method is simply the number of business miles driven during the year multiplied by 36 cents per mile. Any tolls or parking fees may also be deducted in addition to the mileage if it is related to business.

In general any personal related mileage trips are not deductible. As with any general rule, there is an exception to that rule. 

In the recent court case alluded to above, the IRS argued that the taxpayer's mileage was personal and thus nondeductible. The mileage was related to travel for the taxpayer to copy and file his personal tax returns, miles for meeting with the IRS personnel in regards to the examination of his personal income tax returns, miles for a trip to the library and miles for obtaining a document related to the IRS investigation.

The Tax Court disagreed with the IRS and permitted the taxpayer to claim the mileage as a miscellaneous itemized deduction (subject to the 2% adjusted gross income limitation). The Court argued that the taxpayer's expense was "ordinary and necessary in connection with the determination, collection, or refund of tax."

Thus even though the mileage incurred by the taxpayer was related to settling his personal income tax, the taxpayer was able to deduct the miles. If you have a question regarding the deductibility of your mileage, please contact the office. In the meantime begin recording the dates and mileage of any trips related to the establishment of your tax liability. It appears that this should include trips to see your tax professional as well as any audit related trips.

**** Tax Deductible and More ****

The office recently received a subscription renewal notice that closed the letter with: "Your subscription may be tax-deductible." And, of course, it may be. But the letter stimulated thought about a tax deduction which also gives rise to a tax credit savings, a "deal too good to be true," but for the fact that it is sanctioned by Internal Revenue Code Section 25B.

This topic has been discussed in this newsletter before, but it is worth revisiting.  It is referred to as the retirement savings contributions (RSC) credit. Quite simply, it provides a credit of up to $1,000 per person when a contribution is made to an employer-sponsored retirement plan, including a 401(k) plan, or a traditional IRA, or ROTH IRA. In other words, for a married couple filing joint, if their income (adjusted gross income) does not exceed $30,000, they could save up to $2,000.

To qualify for the credit, the individuals must be at least 18 years of age by the close of the year, not a dependent on another person's return, and not a full time student. 

Consider the following case to see how this credit might affect an actual situation. A family with two young children filed their 2002 return. The wife is a homemaker, and the husband earns $30,000 reported on a W-2. Using their 2002 data, they would receive a refund of $1,057. If they contributed $1,500 to a ROTH IRA, the refund would be $1,807, an increase of $750 over the refund of $1,057. Notice that the ROTH contribution of $1,500 saves $750. This means that the net tax cost of the contribution is only $750 ($1,500 into the ROTH less $750 in additional tax savings).

Watch it get even sweeter.  If a Traditional IRA is funded for $1,500, the refund goes from $1,807 to $1,957, a difference of $150 extra. Why? Quite simply, this taxpayer is in the 10% bracket and a deduction of $1,500 for the Traditional IRA saves 10% of $1,500 or $150.

Let's make it super sweet. If you put $1,500 into the 401(k), the refund jumps to $2,273, an increase of $316. In other words, by contributing $1,500 to a 401(k), the tax dollars saved are $1,216. This means that the net tax cost of the 401(k) is only $284! What generates this additional savings? A married couple filing a joint return at this income level is eligible for the Earned Income Credit. The 401(k) contribution reduces the taxable, W-2 income and increases the Earned Income Credit at the same time. 

 A family with income of $30,000 might find it difficult to set aside $1,500 in a 401(k).  But since it costs only $284, the burden is significantly narrowed. Bargains like this are found nowhere else but in Code Section 25B.

**** So You Got a Part Time Job? ****

The Internal Revenue Service (IRS) feels that it is important that students who get part time or summer jobs understand the tax law, so they recently published "Tips for Working Students" on their www.irs.gov website.  The dangers come when you work a short period of time.  Most of the calculations and the IRS tables are computed assuming that the taxpayer is working year round.  If you get a short term job or a summer job all those calculations may mean nothing.

Some students may find that they do not need to have any federal income tax withheld from their pay.  You may be exempt from withholding federal income tax if you can be claimed as a dependent on another taxpayer's return, such as the income tax return of your parents or guardian, you do not expect your total 2003 income to be over $4,750, your unearned income from interest, dividends and other investments, will not exceed $250, AND you had no income tax liability for 2002.  If all these factors match your situation, you may claim exempt on your form W-4, withholding information statement.  Remember that this exemption is only from withholding.  If your income should happen to exceed the thresholds (including tips) mentioned above, you will still be subject to filing a return and paying the tax you owe.

The IRS warns taxpayers that they still have to pay Social Security and Medicare taxes, but skipping unnecessary income tax withholding will put more money in your pocket now.  The IRS also cautions short term workers to read the front and back pages of the Form W-4 carefully before filling it out for your employer. 

One of the monkey wrenches that can get thrown into the machinery of the normal Form W-4 is an employee who works for tips.  There are many tip-based jobs, the prime example of which is waiting tables in restaurants.  If customers tip you, those tips are subject to Federal Income tax, Social Security, and Medicare tax.  The taxpayer (this means you!) is responsible to keep track of the amounts and dates of the tips.  These tips must be included on your federal income tax return, and must be reported to your employer by the middle of the following month so that the correct amount of Social Security and Medicare tax is withheld from the hourly or weekly pay which the employer pays you to supplement the tips.  Some employers only pay you enough to cover the Medicare and Social Security taxes.  If your tips are less than $20 a month you are exempt from reporting them to your employer, but you still must report them on your federal income tax return.

The IRS has provided some interesting publications to help young people deal with the short term job and withholding issues.  "It's Payday" is part of a series of interactive tax presentations for students on the IRS website.  To locate this go to www.irs.gov .  On the left side Contents Menu click on Individuals; then under Contents click on Students.  Under Tax Information for Students, click on "TAXinteractive".  Select "Its Payday" as your Destination.  This article talks about the issues of summer employment in a "kinder and gentler," and perhaps even "fun" way from the IRS perspective.  The tips explanation features a pizza delivery guy who is making money for the first time from tips delivering pizza.  Be sure to check out the five fun phrases for fatter tips.  If you have any questions please call the office, we are happy to make sense of nonsense and to explain the complications of the tax law in an understandable way.  

August Newsletter

Labor Day

Ah, Labor Day, the proverbial end of summer relaxation. The work year seems to begin in earnest after Labor Day, and the children are back in school.

Labor Day reminds us that the Internal Revenue Code taxes labor, and here is where it gets interesting. Under the Tax Relief Reconciliation Act of 2003, the tax rates have dropped by 2 points for each bracket, except for the highest bracket where the drop is 3.6 points. However, the rate of tax on dividends and capital gains is 15%, except for taxpayers in the 10% or 15% bracket, for which the rate of taxation is 5%.

In other words, labor is taxed at a maximum rate of 35%, but dividends and capital gains are taxed at a maximum rate of 15%. This means under the current tax law, there is more money at the end of the day for capital gains and dividends earnings than ordinary income earnings. The sweat of your brow is taxed at a higher rate than your money earning money.

In the next few years fertile minds will come up with ways to convert otherwise regular income to dividends or capital gains.  Obviously, the law should always be followed.  Following are some thoughts to ponder:

Interest income is taxed at a maximum rate of 35%; dividends are taxed at a maximum rate of 15%.

If you have your own C Corporation, and you provide services to the corporation as an employee, you should be receiving a reasonable salary for the work you provide the corporation, the same as any employee would be paid. Monies that the corporation pays you as a shareholder of the corporation, from the earnings and profits of the corporation, are dividends, taxed at the lower rate. This does not work in S Corporations or in Partnerships, but it provides a new, potential advantage to the C corporation form of organization.  However, state taxes should be considered prior to a change in entity structure. 

If you are a C Corporation and you have been retaining earnings in the corporation, now may be a great time to pay out those retained earnings as dividends, which will be taxed at 15% by the recipient. If you are a C Corporation and you have been retaining earnings and you have worried about the Accumulated Earnings Tax penalty, you can lower your worrying since, if the IRS does impose the penalty, it will be imposed at only 15%.

In 2008, the dividend rate and capital gain rate for those in the 10% and 15% brackets will be 0%. Some taxpayers may be able to sell their appreciated assets free of tax in 2008.  

Do be careful. The lower tax bracket is wonderful, but don’t do anything that skirts the law.  Enjoy the special tax benefits sanctioned by Congress.

Child Tax Credit Checks Issued This Month

This month a $400 advance payment for the child tax credit is scheduled to hit mailboxes. Who gets it, when, and how are the questions that parents will want to have answered.

Who gets the check?

Parents with children aged 16 and under get the $400 relief which was signed into law this past May by President Bush. The credit was originally $600 but it is now worth $1,000 for the current year.

When will the check come?

The last two digits of the primary parent’s social security number (SSN) listed on the 2002 tax return will determine the order of mailing of the checks. The mail-out dates follow:

July 25^th for SSNs ending with 00 to 33

August 1^st for SSNs ending with 34 to 66

August 8^th for SSNs ending with 67 to 99

No checks will be sent unless parents have filed their 2002 tax returns. If an extension has been filed, expect to wait at least four to six weeks after the filing of the return. Get that return filed because the IRS will stop issuing checks in late December. As a result, parents will have to wait until they file their 2003 tax returns to receive the $400 credit.

Note that the $400 advance is not a rebate. It’s an advance for the credit parents would have claimed when filing their 2003 tax returns.

How to get the check?

There’s nothing to do except to wait for the IRS to send the checks and the post office to deliver them. The IRS will determine who is a qualified recipient by generating information from the 2002 tax returns. They will analyze the age of the children, parental income and other factors. In the meantime it is a good idea for parents to update their mailing addresses with the IRS; otherwise the checks may not be delivered or forwarded correctly.

Once parents get their checks, they will need to save the IRS notice that comes with the check. The information on the notice needs to be disclosed when filing the 2003 tax return.

What is the amount of the check?

The base amount of the check will be $400 per eligible child. The check amounts start to decrease when modified adjusted gross income exceeds $110,000 for married couples filing joint returns, $55,000 for married couples filing separate returns, and $75,000 for all others. Since the analysis is based on 2002 tax returns, the calculations are not necessarily correct. For instance a newborn or divorce that occurred in 2003 can result in an incorrect check amount. Also income levels may have changed for one or both spouses during the current year.

If the check amount is less than it should be, the difference can be claimed on the 2003 filing. If the amount issued by the IRS is more than the correct amount then parents get to keep that amount.

Final words

It is not necessary to adjust tax withholdings as a result of this child tax credit advance. Also note that the total tax assessed on taxable income for 2003 is not going to change. The advanced credit only reduces whatever credit may have been claimed on the 2003 return.

If you have questions regarding your eligibility to receive the credit, feel free to contact the office.

Statute of Limitation

The office doesn’t want this newsletter to be too technical, but this is an important topic and one on which the IRS just released Publication 1035, Extending the Tax Assessment Period. In order to understand this topic, you need to understand the statute of limitations—the IRS explains:

Assessment statutes of limitations generally limit the time the Service has to make tax assessments to within three years after a return is due or filed, whichever is later. The Service cannot assess additional tax after the time for assessment has expired under any statute of limitations (even if the Service discussed the need for a tax adjustment with you before the expiration). Statutes of limitations also limit the time you have to file a claim for credit or refund. The Service is legally prohibited from making a refund or credit for your claim if you file it after the time for filing has expired under the statute of limitations. Also, if you disagree with the return examination findings, the office cannot provide you with an administrative appeal within the Service unless sufficient time remains on the statute of limitations. Because of these restrictions, the Service identifies tax returns under examination for which the statutory period for assessment is about to expire and requests that you extend the assessment statute of limitations. This additional time allows you to provide further documentation to support your position, request an appeal if you do not agree with the examiner's findings or to claim a tax refund or credit. The extended assessment statute allows the Service time to properly complete the examination of the tax return and to make any additional assessment or reduction in the previously assessed tax liability that is required.

If the IRS asks you to sign a statute extension, please do speak with the office. The extension does, as the IRS explains, give more time to resolve the controversy but this could be good or bad, depending on the facts and circumstances of the case. The IRS typically has 3 years from the due date of the return. For example, a 2000 1040 was filed on the due date of April 15, 2001 . The IRS has until April 15, 2004 to complete the audit.  If the IRS were to start an audit on your 2001, yes—the 2001 return—and ask, as part of the audit, for a copy of the 2000 return to review it and, upon review, then decides to audit that 2000 return, they will ask you for a statute extension on the 2000 return. Should you sign it? Maybe yes, maybe no. If you do sign it, the IRS will have additional time to complete the audit. And if you don’t sign it—difficult to say—the IRS may do nothing and let the year close without further action. Or, the IRS may issue a report disallowing claimed expenses on the return—but they may not have developed sufficient facts to do this. In other words, the request for a statute extension sounds benign, and it may be, but it is not necessarily so.

On the other hand, if you disagree with the IRS and you need more time to appeal your case, a statute extension should probably be signed.

This is not an everyday issue for you, but the office is used to dealing with it. If the IRS ever approaches you with a request to sign a Form 872, 872A, 872B, SS-10, or Form 900, tell them, “I’ll get back to you once I speak with my tax professional.” The office is here to help you with the unexpected.

2003 JULY NEWSLETTER

NEW TAX LAW!

The Jobs and Growth Tax Relief Reconciliation Act of 2003, signed by President Bush on May 28, 2003, is now law. Does it change everything? No, it doesn’t. But it does have many important provisions and it will effect every taxpayer. The law is actually very brief, but it is too long to cover in complete detail. The office is here to help you and will apply the law to your situation and be happy to advise how you can use the law to your advantage. Here are the basic changes. Also be aware that Congress is debating new changes to tax law, which, if passed, we will cover in subsequent newsletters.

Accelerate the Increase in the Child Tax Credit: The $600 child tax credit increases to $1,000 for 2003 and 2004. For 2003, the increased amount of the child care credit (up to $400, which is the new amount of $1,000 for 2003 less the previous maximum of $600) will be paid in advance, beginning in July, based on the information contained in the taxpayer’s return for 2002. This credit is available for a child not yet age 17—so for the additional maximum of $400, it is available only if the children are not yet age 17 at December 31, 2003. Notice that this refund, to be received in 2003, is based on the 2002 tax information, but is based on 2003 law. This means that when you file your 2003 tax return, you will have already received the “extra $400” through this advance rebate.

Marriage Penalty Relief: A few items here. If a married couple takes the standard deduction, rather than itemizing deductions, their standard deduction for 2003 and 2004 will be twice the rate for a taxpayer filing as a single individual. In 2003, the new standard deduction for a married couple is $9,500. If your itemized deductions exceed the standard deduction, the office will file Schedule A, which will result in tax savings beyond the standard deduction amount. But, if you have previously used the standard deduction, you will find tax savings coming your way with the new higher amount. In addition to this benefit, the 15% bracket is now twice the amount of the 15% bracket for individuals filing as single. This means, quite simply, that if you are married filing a joint return, more of your income will be subject to a lower tax rate. These changes also apply to 2003 and 2004 returns.

Tax Rates Reduction: The tax rates for 2003 and the near future (through 2010) are 10%, 15%, 25%, 28%, 33%, and 35%. The 10% bracket is made wider by a bit. Lower rates, lower taxes. The office can do a projection for you to determine your “tax savings”.

AMT: Three letters that can really hurt. The alternative minimum tax is sort of like the Twilight Zone of taxation, a sinister parallel universe that can cause you to pay more tax than your regular tax indicates. This is a complicated calculation, but fewer taxpayers will be subject to it in 2003 and 2004 due to an increase in the alternative minimum tax exemption amount. The increased exemption might not be high enough to keep AMT from eating away at your funds, and Congress will have to revisit the AMT eventually.

Equipment Acquisition: When businesses acquire assets, they can either Section 179 the cost—that is, they can take a current write-off, or they can depreciate the cost (spread it out over several years). Section 179 is a wonderful code section, made even more wonderful under the new law. Starting in 2003—through 2005, a taxpayer can Section 179 up to $100,000 of property; the 2002 limit was $25,000. The change in law also provides that computer software can be deducted under Section 179. If you run your own business, whether as a sole proprietor or as a corporation, this benefit is available.

If Section 179 is not sufficient for you to write off your assets (and there are some restrictions that makes it unavailable sometimes), then the new law provides for bonus depreciation in the amount of 50% of the cost of the asset, versus earlier law’s allowance of 30% bonus depreciation. This bonus is allowed in addition to the regular depreciation allowed. The depreciation allowed on “luxury automobiles” has increased, using the 50% bonus depreciation, from a $7660 maximum in 2002 to a maximum of $10,710 in 2003. (This maximum is only available for automobiles purchased after May 5, 2003. The office is here to crunch those numbers for you.

Reduce Capital Gains Rates: For sales and exchanges (and payments received) on or after May 6, 2003, and before January 1, 2009 the capital gains rate is 15%. For taxpayers in the 10% and the 15% bracket, the capital gains rate is 5%. The 5% rate falls to 0% in 2008!

Reduce Tax on Dividends: Dividends are now taxed, starting in 2003, at the same rate as capital gains, 15%. For those in the 10% and 15% brackets, the rate is 5%.

A word of warning: Tax law changes very frequently. Many of the provisions in the new tax law only exist for two years and then the law reverts to what it was before. It is very difficult to do long term tax planning with such a transitory arrangement. If there is a change in the tax law which will provide advantage, it is generally wise to implement it as soon as you can. It is very difficult to state that changes in this law will be around in the future.  Let the office help you maximize the benefits of these new provisions and evaluate the effect they will have on your taxes.

2003 June Newsletter.

Medical Expenses for Conception

Holidays are very beautiful, but inherent in each celebration for some are seeds of yearning for others. In last month's issue, we spoke about Mother's Day. This month has Father's Day. Both months celebrate parenthood. Philosopher Tagore's quote above celebrates children. Many couples yearn for children but find conception difficult. A brand new IRS ruling, LTR 200318017, provides that expenses relating to obtaining an egg donor and egg donor fees are deductible medical expenses. Let us explore this important ruling, as it does provide hope to many couples. The individuals have unsuccessfully tried repeated assisted reproductive technology procedures to enable them to conceive a child using their own eggs. They desire to attempt pregnancy using donated eggs. Their health plan will pay expenses to fertilize and transfer an egg or embryo to them but will not cover expenses to obtain an egg donor. Are the following expenses medical expenses?

The donor's fee for her time and expense in following proper procedures to ensure a successful egg retrieval.

The agency fee for procuring the donor and coordinating the transaction between the donor and the recipient.

Expenses for medical and psychological testing of the donor prior to the procedure and insurance for any medical or psychological assistance that the donor may require after the procedure.

Legal fees for preparing a contract between the taxpayer and the egg donor.

Taxation of Real Estate Investments

1.      You must have a modified adjusted gross income of less than $100,000. (For incomes higher than $100,000 the benefit will be phased out.) The calculation of modified AGI involves 10 possible adjustments to the standard AGI found on line 35 of the Form 1040. Call us to help you calculate it using last year's income if you want to check your ability to qualify.
 

2.      You must actively participate in the management of the property or properties. This means that you must exercise independent judgment in the making of management decisions for the property. You can not simply turn the property over to a management company and routinely ratify all their decisions.