Michael Gray, CPA's Tax and Business Insight

Table of Contents

• It's time to review estimated tax payments, again.
• The extended due date for calendar year corporations approaches.
• Providing for the college education of your children.
• What does the current Federal budget fiasco mean?
• Partnerships should almost always have written agreements.
• No passive activity income offset allowed.
• Gay couple not allowed to file a joint return.
• Marital deduction not allowed for gay partner.
• Corporate losses not allowed on Schedule C.
• Part of compensation found to be a dividend.
• Momentary ownership of S corporation stock by IRA OK.
• Watch out for tax rebate scam.
• Automatic extension for filing estate tax returns allowed.
• Surviving spouse rollover allowed when not a named beneficiary.
• Note to accountants, attorneys and consultants.
• If you have employee stock options...
• PS Marché Aux Fleurs
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It's time to review estimated tax payments, again.

Many taxpayers had high tax liabilities for 2000 as they bailed out of stocks and stock options. With the market downturn this year, they have not based their estimated tax payments on last year's tax.

If this describes you, remember that the next estimated tax due date is September 17, 2001. It's time to update your tax advisor about what has happened this year to be sure you pay enough estimated tax to avoid underpayment penalties.

Although the new tax law allows calendar-year regular "C" corporations to make their third estimated tax payment by October 1, 2001, I suggest that our readers with calendar year corporations stick with the September 17 date. Avoid screwing up your regular routine, including state estimated tax payments.

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The extended due date for calendar year corporations is September 17, 2001.

'Nuff said!

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Kids are returning to school. Have you provided for the college education of your children or grandchildren?

There are a boatload of new tax benefits for education in the new tax law. The most significant is liberalizing the rules for Section 529 or "Scholarshare" plans. If you haven't already set one or more of these up, look into it. Your beneficiary doesn't even have to be a family member. See your tax advisor.

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What does the current Federal budget fiasco mean?

As many of you have read, the Federal budget surplus for 2001 has evaporated. Two-thirds of the shortfall is from the tax cut legislation that Congress just passed, with most of the benefits going to individuals. President Bush says this is a good thing. The shortfall will force Congress to be more disciplined in making spending decisions.

Most of the real impact of this new legislation won't start to hit until next year - especially the liberalized education and retirement plan provisions.

There are two consequences I see coming from this situation. (1) It will be difficult to impossible to pass any relief provisions without enacting revenue raisers with them. I am very pessimistic that taxpayers with stock options who were clobbered by the market crash are going to get any relief. (2) There is an excellent chance that many of the "phase in" provisions of the law - including estate tax repeal - will stop "phasing".

Remember that the previous President ("Read my lips. No new taxes!") Bush was forced to enact a tax increase after President Reagan enacted significant tax reform and reduction. Our "conservative" President Reagan racked up record deficits to win the Cold War, bankrupting the Soviet Union and nearly bankrupting the United States in the process. How fortunate for us that we had the deepest pockets.

Despite the current President Bush's rhetoric, we simply can't afford to mortgage our children's future any longer. There is a huge bubble of retiring baby boomers coming up. We must prepare for this shift in our population responsibly. If we don't deal with it now, we will be forced to deal with it later - and it won't be pleasant. (Remember the collapse of the real estate, savings and loan, and financial planning industries after repealing the tax stimulus of tax shelters and accelerated depreciation - with no "grandfather" provisions? Remember the collapse of the domestic yacht building industry from the luxury tax?)

(It's easy to be a critic, but hard to give real solutions. Ask ten people how our tax system should work or what our government's spending priorities should be and you'll probably get ten different answers.)

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Partnerships should almost always have written agreements.

Two brothers had a farming partnership, with no written agreement. One partner, James, contributed $1 million and the other, Darwin, $2,300. They had a falling out, and James threw Darwin out of the business. Darwin sued James in state court for the dissolution of the partnership and a determination that each brother was a 50% owner. The state court ruled that profits should be shared equally after the partners were repaid their contributions. James prepared and filed partnership income tax returns reporting each partner had a 50% share of the profits, but he took 100% of the cash distributions from the business.

After James' death, the IRS examined James's estate tax return and discovered this situation. They claimed that all the partnership items should be allocated 100% to James.

The Tax Court ruled the partnership was not terminated when James threw Darwin out of the business, but since James had contributed virtually all of the capital of the business and received all of the cash distributions, and allocated all of the income to James.

This case illustrates the importance of having and following a written partnership agreement for the protection of each partner's legal rights and tax results. In addition, the partnership agreement must have substantial economic effect to be respected by the IRS and the courts.

(Estate of James R. Tobias, TC Memo 2001-37 (2/14/01))

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No passive activity income offset allowed for Self-Charged Items.

The IRS has issued regulations allowing the recharacterization of interest charged by the owner of a passive activity as passive activity income. Recharacterizing income as passive activity income enables the taxpayer to currently deduct more passive activity losses, such as from renting real estate. A taxpayer claimed that other "self-charged" items, such as for management fees, should also be eligible for recharacterization.

The Fourth Circuit Court of Appeals reversed the Tax Court, ruling the IRS must provide for items eligible to be recharacterized in regulations, and disallowed the taxpayer's treatment.

(David H. Hillman, 87 AFTR2d 2001-803 (4/17/01))

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Gay couple not allowed to file a joint return.

A gay couple tried to challenge the rules requiring taxpayers to be married and of the opposite sex to file a joint return, under the equal protection clause of the Constitution. The Tax Court and the Fourth Circuit Court of Appeals ruled against the taxpayers.

(Robert D. Mueller, 2001-1 USTC 50,391 (7th Cir. 4/6/01))

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Marital deduction not allowed for gay partner.

A gay couple lived together for 33 years, held themselves out as married and used the same surname. The decedent partner left nothing to his companion under his will. The surviving partner claimed to be a common law spouse. Alternatively, a tort suit was filed for emotional distress because the surviving partner was not allowed to return to their home after the decedent had a stroke.

The decedent's estate settled the claims, and claimed the amounts paid to the companion on the decedent's estate tax return as a marital deduction or a claim against the estate.

Since the state where the couple lived did not recognize common law marriages of gay couples, the IRS found the marital deduction was not allowed.

The IRS said the claim against the estate might be deductible, but it didn't have enough facts to rule on the issue in this case.

(TAM 200132004)

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Corporate losses not allowed on Schedule C.

Anand Verma set up a home-based business, which he incorporated. The business generated losses, which he claimed on Schedule C of his individual income tax return. The Tax Court ruled the losses were not allowable on his individual income tax return, but must be reported on a corporate income tax return. (Verma should have simply made an S election. Then the corporate losses would have passed through to him, subject to the limit of his investment in the corporation.)

(Anand K. Verma, TC Memo 2001-132 (6/6/01))

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Part of compensation found to be a dividend.

Eberl's Claim Service, Inc. was a claims adjusting business. The corporate sales increased from $600,000 to $4 million because of claims relating to Hurricane Andrew. Eberl's compensation increased from $200,000 to $3 million. The IRS claimed that part of the amount paid to Eberl was not compensation, but a dividend, and therefore not deductible for the corporation.

The Tax Court and Tenth Circuit Court of Appeals ruled a part of the compensation was, in fact, a dividend.

We are seeing more reasonable compensation cases, so closely-held C corporations should be aware of the issue. When a taxpayer has an S corporation, most of the bite of this issue is eliminated. (For S corporations, the IRS will attempt to recharacterize dividends as compensation to collect payroll taxes.)

(Eberl's Claim Service, Inc., 2001-1 USTC 50,396 (10th Cir. 5/4/01))

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Momentary ownership of S corporation stock by IRA OK.

Now that S corporations can have an ESOP, the issue has arisen whether a distribution of S corporation stock can be rolled over to an IRA. The IRS ruled that, provided the corporation immediately redeems the stock after the rollover, this is OK.

(Private Letter Ruling 200122034)

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Watch out for tax rebate scam.

It's hard to believe, but someone is charging for the "service" of determining the amount of the rebate a taxpayer is entitled to and when to expect the rebate check. The IRS has issued a letter providing this information for free. Don't get suckered in by this one.

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Automatic extension for filing estate tax returns allowed.

The IRS has issued final regulations eliminating the requirement for the executor of an estate to receive IRS consent for a six-month extension of time to file the estate tax return, Form 706. Automatic extensions are now available for estate tax returns due after July 25, 2001, by filing Form 4768 by the original due date. The form may be signed by the executor or authorized representative, an attorney, CPA, or enrolled agent authorized by the executor, or by an authorized agent holding a power of attorney.

IRS consent is still required for an extension of time to pay the tax.

(T.D. 8957, Reg. 38,544)

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Surviving spouse rollover allowed when not a named beneficiary.

A decedent did not name his spouse as the beneficiary of his IRA and died without a will. Under state law, the decedent's estate was the beneficiary of the IRA, and the surviving spouse was entitled to the entire estate. Therefore, the surviving spouse was permitted to rollover the deceased spouse's IRA to her own, tax free.

(Letter Ruling 200129036)

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Note to accountants, attorneys and consultants.

I recently read Professional's Guide to Value Pricing by Ronald J. Baker. This isn't a general interest business book, so I won't be writing a review on it, but Ron has put a lot of thought into a fundamental part of our business - how we bill our clients. If you haven't read this book yet, add it to your reading list.

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

To subscribe, go to http://www.stockoptionadvisors.com. You can review past issues at http://www.stockoptionadvisors.com/optionalert/.

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P.S.

My daughter and her husband, Holly and Dan Baker, have opened a Southern French Restaurant at 23 Ross Common, Ross, California, about 15 minutes north of the Golden Gate Bridge. The name of the restaurant is Marché Aux Fleurs. For the best meal of your life, call 415-925-9200 for a reservation and give them a try soon! For directions, visit our website at http://www.taxtrimmers.com/directions.shtml.

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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.