Michael Gray, CPA's Tax and Business Insight

Table of Contents

• It's tax season!
• What does the future hold for tax legislation?
• Subscribe to the ESOAA Option Alert!
• Thank you!
• IRS issues alternative LIFO rules for used vehicles.
• Required minimum distributions from retirement plans.
• New rules issued for cafeteria plans/flexible spending accounts.
• IRS is re-examining split-dollar life insurance plans.
• IRS reduces benefits of charitable remainder trusts.
• Supreme Court settles S corporation basis issue ... for now.
• California makes significant change in corporate tax laws.
• California tax laws trapped in time warp!
• California businesses must report independent contractors.
• Partially tax-free IRA distributions for new CA residents.
• Visit our new articles
• Subscribe/Unsubscribe from Michael Gray, CPA's Tax and Business Insight



It's tax season!

We have finally sent out all of the tax organizers and Tax Notebooks to continuing clients and people we expect to be preparing tax returns for. If you haven't received one and are planning for us to prepare your income tax returns, please call Dawn at 408-918-3162. We will not be having appointments after March 1. Not everyone will need an appointment. If you will, reserve your date now.

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What does the future hold for tax legislation?

President Bush has indicated that he is determined to enact a tax cut. Some items on the wish list for many people include the repeal of the estate tax and the repeal of the alternative minimum tax for individuals. Considering our slowing economy and other issues, like the energy crisis in California, Congress may not back the President in an aggressive tax cut. I give him 50% odds.

Also, a tax cut will probably be "phased in," which gives Congress wiggle room for change later.

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If you have employee stock options, have you subscribed to the ESOAA Option Alert?

The latest issue includes a discussion about an IRS announcement about withholding for the sale of ISO shares and ESPP shares. To subscribe, go to http://www.stockoptionadvisors.com. You can review past issues at http://www.stockoptionadvisors.com/optionalert.

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Thank you!

Mike Agah referred Benit Ganja. Thank you for your thoughtfulness.

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IRS issues alternative LIFO rules for used vehicles.

The alternative LIFO computation method is much simpler and less expensive than making a detailed computation. The IRS previously gave rules on how to use this method for new vehicles, and now has issued a procedure to use it for used cars and trucks. I will mention that the inflation adjustments computed using LIFO for used vehicles for one of my clients has been small or negative, so don't feel compelled to jump into this election. It will be beneficial if high inflation ever returns to our economy. (Rev. Proc. 2001-23.)

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New rules issued for required minimum distributions from retirement plans.

Most people know that distributions must start from IRA accounts and most retirement accounts by April 1 of the tax year following the year the taxpayer reaches age 70 1/2. Computing the required distribution has been very complicated because it has been based on certain actuarial assumptions and elections of the taxpayer. The IRS has issued new guidelines about how the required distributions are computed that will simplify this process. During the plan participant's lifetime, the distributions will be computed using one table. (An exception will be allowed when the required distribution can be reduced by taking into account the age of a beneficiary who is a spouse more than 10 years younger than the plan participant.)

Instead of determining the designated beneficiary as of the beginning date for required distributions, the designated beneficiary will be determined as of the end of the year following the year of the employee's death. If there are multiple beneficiaries and the account isn't split up, the shortest life expectancy will be used. (It's still important to have designated beneficiaries in the plan to avoid the requirement to distribute the plan account within 5 years after the participant's death.)

The regulations are proposed to be effective for calendar years beginning on or after January 1, 2002, but taxpayers may elect to apply them for distributions during 2001. See your tax advisor about what is to your advantage. (NPRM Reg-130477-00)

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New rules issued for cafeteria plans/flexible spending accounts.

The IRS has issued final regulations relating to cafeteria plans, also called flexible spending accounts or Section 125 plans. The new rules provide guidelines about when employees can change their election of the amount of withholding contributed to the plan because of changed circumstances. Some circumstances for which a change is allowed include birth, adoption, placement for adoption, death, and change in marital status. (T.D. 8921)

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IRS is re-examining split-dollar life insurance plans.

The IRS has indicated that the old rulings for the treatment of split-dollar life insurance plans will be revoked or modified. The payments made by an employer under a split-dollar arrangement must be accounted for as a loan, investment in the contract for the employer's own account or as compensation payments. In some cases, the below-market rate interest rules of IRC Section 7872 may apply.

If the employer is treated as having a beneficial ownership in the life insurance contract through its share of the premium payments, the employee will have compensation income equal to the value of the life insurance protection each year that the arrangement remains in effect plus any dividends or distributions made under the contract.

If an employer makes a premium or other payment under a split-dollar arrangement, but does not acquire a beneficial ownership interest in the contract and does not have a reasonable expectation of repayment through policy proceeds or otherwise, the payment will be treated as compensation to the employee.

An interim premium rate table was provided for taxpayers to determine the value of current life insurance protection on a single life for tax years ending after January 9, 2001. The old P.S. 58 rate table is obsolete.

The IRS is seeking comments in the process of determining the final rules in this area. (Notice 2001-10.)

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IRS reduces benefits of charitable remainder trusts.

The IRS has issued regulations to eliminate a perceived abuse for charitable remainder trusts. The abuse is when taxpayers contribute appreciated property to the trust and the trust avoids generating capital gains to distribute to the taxpayers by borrowing, using the property as security, or by making a forward sale of the property effective when it is distributed to a charity. The funds are used to make lifetime distributions to the taxpayers as lifetime beneficiaries of the trust. Under the new rules, the trust is deemed to have made a sale of a pro-rata share of the trust assets to the extent the distribution of the annuity or unitrust amount would be characterized in the hands of the recipient as a distribution of capital gains from the current or previous years.

The regulations are generally effective as of January 5, 2001, but can also apply to distributions made after October 18, 1999. (T.D. 8926)

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Supreme Court settles S corporation basis issue ... for now.

The various courts have been issuing conflicting opinions about whether the tax basis of a shareholder's stock in an S corporation should be increased for cancellation of indebtedness income of the S corporation that is exempt from income tax. The Supreme Court has ruled that the basis increase is allowed. (Gitlitz, Supreme Court, 1/9/01.)

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California makes significant change in corporate tax laws.

For years, there has been an issue for accrual-basis corporations about the proper year to deduct California franchise taxes. The structure has been that the tax determined based on income for a year is a tax paid for the privilege of doing business in California the next year. Under that arrangement, the tax deduction on the current year Federal income tax return is the tax from last year's California tax return.

California has adopted a change in the structure of its tax laws. Effective for taxable years beginning on or after January 1, 2000, the references in California's Revenue and Taxation Code of "income year" have been changed to "taxable year."

Therefore, it appears that accrual-basis corporations formed on or after January 1, 2000 may deduct the California tax based on the current-year return.

Other corporations are probably stuck with deducting the tax based on last year's California return because of Internal Revenue Code Section 461(d), which prohibits a double deduction of taxes because of a legislative change. (AB 2896.)

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California tax laws trapped in time warp!

California has been slow in conforming to Federal tax law changes. In fact, with specified exceptions, the California Revenue and Taxation Code has adopted the Internal Revenue Code as of January 1, 1998! (Perhaps more significantly, California has never conformed its corporate depreciation rules to adopt ACRS or MACRS. Corporate depreciation deductions are determined under the federal rules in effect before 1981!)

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California businesses must report independent contractors.

The Employment Development Department has sent employers new Form DE 542. This form must be completed for any independent contractors who do work for a business or government entity for $600 or more on or after January 1, 2001. The form is due within 20 days after entering into a contract with an independent contractor for $600 or more or after making more than $600 in payments in any calendar year.

If a business is headquartered in California, forms should be submitted for any independent contractors retained nationwide. If a business is headquartered outside California, forms are only required for California independent contractors.

The reason for this procedure is a good one - to help collect child support from deadbeat parents. As taxpayers, this should reduce costs for welfare and other government benefits.

It's too bad this has to be such a "shotgun" approach. 99.9% of the reported independent contractors probably aren't deadbeat parents, and many aren't parents at all! I just know this will be one of your favorite new compliance items for 2001. (Ugh!)

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New California residents could have partially tax-free IRA distributions.

If a California non-resident moves to California with an IRA account funded from annual contributions, the new resident has a basis in the contributory IRA equal to the fair market value of the IRA when the taxpayer became a resident of California. (FTB Pub. 1005.) Future payments from the IRA will be California tax-free up to that basis amount.

If the IRA was funded from a rollover from a qualified pension plan, the taxpayer will have a zero basis in the account. All of the distributions from the account will be taxable for California.

If the IRA includes funds from annual contributions plus rollover amounts, the taxpayer must make a reasonable allocation of the earnings on the IRA to compute the basis. (Appeal of Douglas T. and Mabel E. Mages, 95N-1074, November 13, 1996.)

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IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this communication was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.