Sales of Livestock Due to Drought

The drought in the Texas Panhandle and surrounding areas has staggered the livestock industry. Many livestock farmers have been forced to liquidate their herds entirely, or at an abnormal rate. The Code provides some tax relief available for farmers who have sold livestock due to the drought. The two principal provisions are Section 1033 and Section 451.

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Make Sure Your Compensation Plans Are in Order and Documented

I recently finished resolving a dispute between a client and the IRS regarding the amount of compensation for the founder and owner of a corporation. While the amount of compensation during one of the years at issues was probably unjustifiably high if viewed by itself, the person's compensation over the years (and including the year in dispute) was readily justifiable when viewed over the entire period that the person worked for the business. We ended up resolving the dispute and the resolution was within $50,000 in compensation from my initial evaluation of the case. But it was an expensive "victory" for the client.

The strongest point for the IRS, and the reason it took as much time and expense to resolve, was the client’s lack of documentation of a consistently applied compensation plan. The client had annual minutes (which many clients do not), but those minutes did not address how the owner’s compensation was determined. The client also did not have a written employment agreement, nor did they have any written (or “understood”) basis for calculating the client’s incentive compensation each year. This lack of a consciously determined pattern to the compensation ended up costing the client several thousand dollars in attorneys fees, and a like amount in additional taxes.

The moral of the story: properly pay and report compensation to employee/owners as such; have a written employment agreement or at least some sort of documentation in your minutes of the oral arrangements for compensation; make sure you have a documented or easily proved method for determining incentive compensation that is reasonable in amount.

 

Turning Startup Profits into 100% Tax-free Gains under the Qualified Small Business Stock Rules

Venture capitalists and private equity groups are reportedly taking an interest in structuring startups to qualify under the qualified small business stock (QSBS) provisions of Code Sec. 1202. It's not hard to see why — this often-overlooked Code provision can turn much or all of the profit on a successful investment in a startup into tax-free gain. But time may be of the essence: Under current law, the 100% exclusion won't apply for QSBS acquired after 2011.

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Obama Wants to Change How All Businesses Are Taxed?

According to Bloomberg News, Geithner Says Tax Overhaul Must Address Businesses Filing as Individuals. It is not clear from the article exactly what this means. It could mean that the administration wants to impose the same type of taxes on all businesses, whether they are incorporated or not. Or it could be something less sinister. But, in either event, it does look like tax changes will be proposed by the administration to all business taxes, whether they are earned by C corporations or pass-through entities. We'll continue to monitor the situation to find out exactly what the administration has in mind.

Gifts by Parents to Fund a Child's Roth IRA

A recent article (Family tax savings compound when a parent funds a child's Roth IRA, R.E. Coppage and L.M. Blum, 82 Practical Tax Strategies 212 (April 2009).) presents an extremely interesting idea – gifting to provide a child funds to contribute to a Roth IRA. Article describes how, not only does the child reap the usual benefits from a Roth IRA and from early retirement savings, but there is also a net tax savings within the family as a whole when such a plan is implemented. Considering the magnitude of the accumulated tax savings, the authors believe a cash gift to fund a child's RIRA contribution is one of the most caring, thoughtful, and practical gifts a parent can make to a child, and I would agree with their conclusion.

Year End Tax Planning

As the end of the year approaches, it is a good time to think of planning moves that will help lower your tax bill this year and possibly the next. Factors that compound the challenge include the stock market's swoon, the difficult economic climate we're in right now, and the strong possibility that there will be tax changes in the works next year. In fact, there might even be another economic stimulus package carrying tax changes enacted before the end of this year.

The good news: Congress has acted to “patch” the AMT problem for 2008, has retroactively reinstated a number of tax breaks (such as the option to deduct state and local general sales tax instead of state and local income tax and the above-the-line deduction for higher education expenses), and has created new tax breaks that go into effect for the 2008 tax year (including a tax credit for first-time homebuyers, a nonitemizers' deduction for state and local property tax and a nonitemizers' deduction for certain disaster losses). For 2008, businesses enjoy tax breaks such as a beefed-up expensing option and a 50% bonus first-year depreciation write-off for most machinery and equipment placed into service this year and a reinstated research credit.

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Covered Opinions under Circular 230

IRS's rules on written advice provided to clients by tax practitioners have been tightened. Anyone who obtains the services of a professional tax advisor should be aware of how these new rules affect the advice they receive.

The rules are contained in “Circular 230” and apply to “covered opinions” (formerly known as “tax shelter opinions”). A covered opinion is defined as written advice, including electronic communications (i.e., e-mail, faxes), on a federal tax issue arising from

  1. a transaction IRS has determined is a tax-avoidance transaction,
  2. a partnership or other entity or investment plan, or any other plan or arrangement, that has tax avoidance or evasion as a principal purpose, or
  3. a partnership or other entity or investment plan, or any other plan or arrangement, that has tax avoidance or evasion as a “significant purpose,” if the written advice is a “reliance opinion” (explained below), or “marketed opinion” (i.e., the opinion will be used by a promoter to market an investment).

Since the term “significant purpose” is not precisely defined, the rules could conceivably apply to routine tax advice provided in writing.

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Preserving Franchise Tax NOLs

I received my form from the Comptroller this week: Texas Franchise Tax Preservation of Temporary Credit. If you have any losses that you were carrying forward for Texas Franchise Tax purposes, don't throw this form away. Fill it out and send it in. If you don't, you will lose any benefits from those prior losses when it comes to the "new" Texas Franchise Tax -- lovingly christened "the margin tax."

Treasury Department Releases Study on Income Mobility of Individuals

The study on income mobility of U.S. taxpayers from 1996 through 2005 revealed that "a majority of American taxpayers move from one income group to another over time." The major findings of the study included:

  • approximately half of the taxpayers who began in the bottom quintile moved up to a higher income group within 10 years
  • about 55% of taxpayers moved to a different income quintile within 10 years
  • among those with the very highest incomes in 1996, the top 1/100th of 1%, only 25% remained in the group in 2005
  • median real incomes of all taxpayers increased by 24% after adjusting for inflation
  • real incomes of two-thirds of all taxpayers increased over the 10-year period

Problems with Return Preparer Penalties

We previously commented on the new return preparer penalties and the problems they will cause. Richard Lipton provides some additional insight into those problems in RIA's Federal Taxes Weekly Alert:

First, Congress has created a “disconnect” under which a return preparer could be subject to penalty in a situation in which the understatement did not result in any penalty for the taxpayer.

For example, assume that a preparer does not disclose a position for which there is substantial authority but which the preparer doesn't believe is more likely than not to be correct. IRS determines that the position results in an understatement of liability. The taxpayer would not be subject to penalty because there was substantial authority for the position, but the return preparer would because the position wasn't disclosed. Congress could easily address this problem by providing that taxpayers (as well as return preparers) are subject to penalty any time that a position on a return wasn't reasonably believed to be more likely than not correct at the time the return was filed.

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Using a Vacation Home as a Retirement Vehicle

This idea comes from Christopher J. Fenn, CPA, in his article "Apply Weath Protection Strategies for 2007 and Beyond" published in WG&L's Practical Tax Strategies.

An alternative or supplement to qualified plans can be a vacation home, particularly for those with children. While the children are living at home, the family enjoys the “retirement fund” on weekends. After the children leave for college, the parents make the vacation home their principal residence. Up to $500,000 of the gain on sale of the former principal residence is tax free, while any remaining gain is currently taxed at 15%. Once the parents have owned and occupied the former vacation home as their principal residence for at least two years, they become eligible for another $500,000 exclusion on the later sale of that second principal residence.

In comparison, withdrawals from a taxable plan such as a 401(k) would be subject to the higher ordinary rate (up to 35%). If the parents decide not to sell the second principal residence and instead allow it to transfer to the children after death, the entire appreciation on the home would escape income tax because it would be treated as an inheritance.

Divorce and Income Tax Consequences

The income tax issues of alimony, child support, and property settlements are generally straightforward but worth reminding.


Alimony

Properly structured, alimony payments are considered gross income to the recipient, and are deductible to the payor. To qualify as alimony, all of the following must occur:
  • The payment must be made in cash.
  • The payment must be made pursuant to a divorce or written separation agreement.
  • If divorced or legally separated, the couple must live in separate households.
  • Payments made on behalf of the recipient spouse to a third party must be evidenced by a timely executed document.
  • The payor’s obligation to make the payment terminates at the recipient’s death.
  • The couple does not file a joint tax return.
  • The divorce or separation agreement does not provide that the payments are not considered alimony.
Normally, the paying ex-spouse does not have to withhold taxes on alimony payments. It is the responsibility of the recipient ex-spouse to make sure sufficient taxes have been withheld or estimated taxes have been paid. If the recipient spouse is a nonresident alien, a withholding tax may be imposed on alimony payments.

While the alimony rules seem fairly straightforward, this is one area in which drafting documents without proper tax advice can have disturbing consequences. For example, in one Tax Court case, a taxpayer drafted his own settlement agreement. Because of improper language, the court ruled that $34,000 in “alimony” payments were instead a nondeductible property settlement. Not only did the husband lose a $34,000 deduction, the court also imposed an accuracy-related penalty.


Child Support

Payments designated as child support are not deductible by the payor or taxable to the recipient parent. A payment is deemed to be for child support if any one of the following occurs:
  • The divorce agreement designates it as child support.
  • The payment reduces at times tied to a child’s pivotal birthdays (e.g., age 18).
  • The payment reduces when an event occurs to the child (e.g., marriage).
  • The payment reduces at a time clearly associated with a child-related event.
An issue related to child support is deciding which parent receives the dependency exemption for the child. Assuming all of the dependency exemption requirements are met, the parents themselves can decide which parent is entitled to the exemption for a minor child. However, once the child reaches majority, the parent claiming the dependency exemption must supply over 50% of the child’s support.


Property Transfers

Most property transfers that are “incident to divorce” are not taxable to either spouse for income tax purposes. However, there are some situations in which income taxes may be imposed, including:
  • A stock redemption done as a result of a divorce.
  • A property settlement made with a nonresident alien.
  • A direct transfer of property to a divorcing spouse is not taxable even when the liabilities secured by the property exceed the transferor’s basis in the property. However, if the transfer of the same property is made to a trust for the benefit of the divorcing spouse, the difference between the secured liability and the basis in the property may be taxable to the transferor.
  • Accrued interest on Series E and EE U.S. Savings Bonds must be recognized by the transferor of the bonds.
  • Many divorcing spouses make settlement payments over a number of years. Any interest on an installment obligation will be taxable to the recipient spouse.

Qualified Plan Rollover Rules Liberalized for Non-Spouse Beneficiaries *

In August 2006, Congress passed the Pension Protection Act of 2006 (the “Act”), a massive tax bill that contains liberalized retirement account payout and rollover rules. Following is a summary of one of the key tax changes in this important new legislation—non-spousal rollovers for beneficiaries who inherit a qualified plan (such as a 401(k)), governmental Section 457 plan, or tax-sheltered annuity.  

Pre-Act law had harsh income tax consequences for non-spouse beneficiaries who inherited any of the above plans.  Non-spouse beneficiaries were generally forced to collect the entire balance within 5 years following the owner's death, and some employer plans required that the payout be made within 1 year or as a lump sum. Either way, the result was a huge income tax burden on the recipient because the inherited amounts that could not be rolled into an IRA were taxable income in the year they were distributed.  The payout was added to the beneficiary's other income, often pushing them into a higher tax bracket. In contrast, payouts to the decedent's spouse from a 401(k) could be—and still can be—rolled over into the surviving spouse's IRA or stretched over the spouse's lifetime, thus stretching out the income tax burden.

Beginning in 2007, the Act allows non-spouse designated beneficiaries to make rollovers of inherited amounts in any of the above plans to either (i) an IRA or (ii) an individual retirement annuity, established for the purpose of receiving the distribution on behalf of the employee's designated beneficiary. This allows beneficiaries to spread the distributions and the taxable income over several years, and, better yet, the inheritance, less required distributions, continues to appreciate income tax-deferred. The transferee plan is treated as an inherited IRA under which benefits must be distributed in accordance with the RMD rules that apply to inherited IRAs of non-spouse beneficiaries.

Cautions: (1) In order for the non-spouse transfer to take place, the plan must allow it.  Check with your Plan Administrator to make sure the plan allows a direct transfer to an inherited IRA for a non-spouse beneficiary.  (2) The law stipulates that the funds must be moved in a trustee-to-trustee transfer.  This means that the beneficiary cannot receive a check and then deposit the check into an inherited IRA.  Rather, the plan must make the check payable to the trustee or custodian of the inherited IRA, making it a qualifying transfer. (3) The rules described above apply to distributions from qualified plans, but also apply to distributions from some other plans. If you are in the process of inheriting an employee’s retirement plan, seek professional tax advice as to the new options that may be available.

 * Taken in part from RIA's "Complete Analysis of the Pension Protection Act of 2006"

Charitable Giving From IRA's *

Please Note:  This article is only relevant for charitable giving from your IRA through the end of 2007.

In August 2006, Congress passed the Pension Protection Act of 2006 (the “Act”), a massive tax bill that contains liberalized retirement account payout and rollover rules.  Following is a summary of one of the key tax changes in this important new legislation—charitable giving.

The Act contains provisions to provide additional tax incentives for Americans to give more resources to the charitable community.  One incentive allows taxpayers to exclude from gross income (“GI”) certain distributions of up to $100,000 from a traditional or Roth IRA if made to a tax-exempt organization to which deductible contributions can be made.

Under pre-Act law, if an amount withdrawn from a traditional or Roth IRA was donated to a charitable organization, the rules relating to the tax treatment of withdrawals from IRAs applied to the amount withdrawn, and the charitable contribution was subject to the normally applicable limitations on deducting charitable contributions.

However, under the Act, for distributions in tax years beginning in 2006 and through the end of 2007, the Act provides an exclusion from GI, up to $100,000, for otherwise taxable IRA distributions from a traditional or Roth IRA that are qualified charitable distributions.  Additionally, the amount of the qualified charitable distribution counts towards the taxpayer’s required minimum distribution (“RMD”) for the year. To constitute as a qualified charitable distribution, the distribution must be made: (1) directly by the IRA trustee to a qualified public charitable organization; and (2) on or after the date the IRA owner attains age 70 and 1/2. 

A qualified charitable distribution is excludible from GI only to the extent that the distribution would otherwise be includible in GI, is counted toward the taxpayer’s RMD requirement for the year, and is not taken into account in determining the individual's charitable contribution deduction for the year. In other words, the qualified charitable distribution is a free gift to charity with no negative income tax consequences to the donor.

The new provision clearly saves taxes for those taxpayers who do not itemize, but can also save taxes for taxpayers who itemize to the extent charitable limitations would have reduced the amount deducted.  Even if limitations would not cause a reduction in the amount of the charitable deduction, the new provision can still save taxes by lowering adjusted gross income (“AGI”) and thereby making it less likely to lose certain tax breaks pegged to AGI, such as medical expense deductions.  Finally, using IRA distributions, rather than other funds, to make charitable contributions can help to reduce the amount of social security benefits included in gross income.

Cautions:  (1) The exclusion does not apply to distributions from all types of IRAs (it does not apply to distributions from SEPs). (2) The exclusion applies only to contributions to qualified public charities. (3) A qualified charitable distribution must be made directly by the IRA trustee to a charitable organization.  Thus, a distribution made to an individual, and then rolled over to a charitable organization, would not be excludible from GI.  (4) If the IRA owner has an IRA with nondeductible contributions, a special rule applies in determining the portion of a distribution that is includible in GI and thus is eligible for qualified charitable distribution treatment. (5) Not all plans will allow this charitable distribution. So before planning any charitable gifts from your IRA, ask your Plan Administrator and your financial advisor to determine whether your plan will allow a gift to a charity and whether your distribution will qualify as a qualified charitable distribution.

* Taken in part from RIA's "Complete Analysis of the Pension Protection Act of 2006"

Deducting Business Travel that Involves some Pleasure

Some reminders about getting a travel bargain by attaching a vacation to an out-of-town business trip: If set up right, you may get free vacation airfare or mileage, and perhaps other savings.

Trips undertaken primarily for business A taxpayer who mixes a bit of pleasure with business while away from home may still deduct all of the round-trip transportation costs as long as the trip was undertaken primarily for business reasons. The cost of lodging plus 50% of meals while on business status is deductible. If you tack on a day or few for a little personal pleasure time, you still get a deduction for the entire transportation cost as well as lodging and 50% of meals for the portion of the trip that is business. [You can’t deduct anything for the lodging and meals for the extra pleasure days.] Because you still get to deduct 100% of the transportation cost, you do get some subsidy for the cost of your min-vacation.

Saturday night stayovers Even if an employee's out-of-town business duties end on Friday, his or her employer may ask the employee to stay over a Saturday night to take advantage of a low-priced fare if the airfare savings exceeds the costs of the weekend’s meals and lodging. The employee doesn't have to pay tax on the reimbursement for his Saturday meal and lodging expenses. And, the IRS, under a “common sense test,” has ruled that payments to the employee for the Saturday stay were deductible if a “hardheaded business person would have incurred such expenses under like circumstances.”

Weekends Similarly, a business trip may straddle a weekend. For example, you may have to attend business meetings on Thursday, Friday, and Monday. If you are too far away to travel home and then come back (or the trip back and forth would cost more than staying put), staying the weekend relaxing at the out-of-town location is part of the business trip.

Weekend travel home A business traveler on an extended out-of-town assignment may decide to fly home for a weekend to be with the family. The cost of the weekend trip home is deductible up to the amount the traveler would have spent on meals and lodging at the out-of-town location. For this rule to apply the traveler must check out of the out-of-town hotel before leaving for the weekend trip home, and then re-register. If, instead, the traveler retains the hotel room, the deduction for the weekend trip home (i.e., the air fare) is limited to what the traveler would have spent on meals during the weekend at the out-of-town location.

When spouse comes The expenses of a spouse or other companion accompanying a traveler aren't themselves deductible unless (1) the spouse or other companion is an employee of the taxpayer and travels for a bona fide business purpose, and (2) the expenses would otherwise be deductible by the spouse or other companion. However, the business traveler may still deduct the cost that would have been incurred in single travel. So, for example, if the cost of lodging is the same whether the room has one occupant or two, the entire cost of the room may be deducted, even if it is shared with a companion who is not a business traveler.