Michael Gray, CPA's Tax and Business Insight

Table of Contents

• Happy Fourth of July!
• Marchè Aux Fleurs offers special Wine Dinner.
• A comparison of "destinations."
• It's time for mid-year tax planning meetings.
• IRS postpones employment taxes for ISOs and ESPPs.
• Unfavorable Supreme Court ruling on tips reporting.
• IRS finds a flaw in the armor of family limited partnerships.
• Eleventh Circuit upholds LIFO loophole.
• Taxpayer may not deduct ex-spouse's attorney fees as alimony.
• "Last Chance" for Retirement Plan GUST amendments.
• Qualified plans must be amended for new minimum distribution rules.
• IRS issues new Net Operating Loss carryback form.
• Employee equipment rental arrangements must meet accountable plan requirements.
• All Federal S Corporations are also California S Corporations.
• Questions and Answers

  Can I use the deemed sales election to create gains to offset some AMT credits?

  How much money should I reinvest in my business?

  Is there a luxury tax on motorhomes in Illinois?

  Has the 24-month occupancy rule for sale of principle residence exclusions changed?

  Do I owe California taxes for time I lived in Australia?

  Do I have to pay taxes on money received passed on to me from my father's estate?

  Can I make SEP IRA contributions based on estimated income?

• Can we save you mortgage dollars?
• Do you have employee stock options?
• Subscribe/Unsubscribe from our newsletter.
• PS Marché Aux Fleurs

Happy Fourth of July!

As a country, we have our share of controversies and nonsense. We also have many blessings to be thankful for. It's time to remember the principles upon which our country is founded, and rededicate ourselves to them. Our system is one of limited government, protecting the rights of citizens from infringement by the state. Preserving those rights requires that we be alert for when our government exceeds its bounds, and working within the system (our representatives and the courts) to challenge infringements of our rights.

It's particularly challenging to do this during a period of war or threats to our national security. We need to remember what we are defending, and it's not just "the homeland."

Have a safe, enjoyable Independence Day.

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Marchè Aux Fleurs offers special Wine Dinner.

Marchè Aux Fleurs is a restaurant located in Ross, California featuring the cuisine of Provence, France, owned by Holly and Dan Baker, my daughter and her husband. Marchè Aux Fleurs has been favorably rated by Zagat, particularly for its wine selection. On Tuesday, July 16, Marchè Aux Fleurs will feature a Bordeaux Wine Dinner, with a wine selection for each course of the meal.

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A comparison of "destinations."

Janet and I enjoyed a family vacation on the Big Island of Hawaii earlier this month. It is a fascinating place to visit, with a lot of variety in landscape on different parts of the island, from desert lava to sandy beaches and lush jungles.

It was interesting to compare two hotels that we visited.

The Hilton Waikoloa Village is enormous. It is clearly a Disney-inspired resort. You can choose transportation around the resort on boat rides or a monorail. A major attraction is to "swim with dolphins." There is a huge water playground. We saw a lot of people at this resort.

The Mauna Kea resort has one of the most beautiful beaches in the world. The snorkeling is outstanding. We swam with several sea turtles there. At night, they shine a lamp to attract manta rays for guests to observe. It also has upscale shops, a golf course, and tennis courts (also available at the Hilton). Although we personally prefer the Mauna Kea for a relaxing vacation, the beach was almost empty and we didn't see many guests.

Early June is the "off season" for Hawaii, which might have been a factor in what we saw. The Hilton undoubtedly has a bigger marketing budget than the Mauna Kea. The contrast in results is interesting. I think the Hilton has been more successful in presenting itself as a self-contained resort for families. There are activities there to appeal to different age groups.

It's worth thinking about from a marketing point of view. Janet and I would prefer to stay at the Mauna Kea when we visit the island again.

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It's time for mid-year tax planning meetings.

2002 is already half over! How is your situation shaping up? Look back at some of the goals you have made for this year. How are they progressing? Should your withholding be adjusted to avoid penalties for underpayment of estimated tax? Would you like a "sanity check" about your investment diversification? Have you prepared and implemented an estate plan? Do you need help in gift planning? Education planning? Succession planning? Implementing a new accounting system? We are ready to assist you.

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IRS postpones employment taxes for ISOs and ESPPs.

See the June 26, 2002 issue of ESOAA Option Alert for details. To see this issue and for a free email subscription, go to www.stockoptionadvisors.com/optionalert.

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Unfavorable Supreme Court ruling on tips reporting.

The Supreme Court disappointed employers whose employees receive tips with their ruling in United States v. Fior D'Italia (Supreme Court 6/17/2002). The Supreme Court reversed a 9th Circuit Appeals decision and ruled the IRS may estimate an employer's liability for FICA taxes by applying the rate of tips from credit card slips to the employer's gross receipts. The ruling will have the biggest impact on the restaurant industry.

The unfortunate result is to create an adversary relationship between employers and employees. The employer won't be able to simply rely on the employee's report of tips, but will have to compare the tips reported by the employee with the amount on credit card receipts and extend the tip rate to other gross receipts.

The trade association for restaurants will be lobbying to change the tax laws on this issue. Meanwhile, the IRS has a powerful audit weapon to apply to employers whose employees receive tips.

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IRS finds a flaw in the armor of family limited partnerships.

The Tax Court ruled in Christine M. Hackl (118 TC No. 14 (3/27/02)) that the restrictions in an operating agreement may be so severe that the person who receives a gift of the interest doesn't have a present interest qualifying for the annual $11,000 gift exclusion. This means more of the transfer may be subject to gift tax or be applied to the lifetime exclusion for the person making the gift.

In this case, the entity was a limited liability company for a tree farming operation, so current income distributions weren't produced. The operating agreement denied members any right to withdraw; or to demand and receive property or any distribution; or to transfer, assign, convey, sell, encumber, etc. all or any part of the member's interest without prior consent.

According to Judge Russell Nims, a gift of a present interest must confer on the donee an unrestricted and noncontingent right to use, possess and enjoy the units, or income from the units, in any manner desired.

If they want to qualify gifts for the annual gift tax exclusion, people using entities to qualify for valuation benefits should avoid creating restrictions that will disqualify for this tax benefit. This is a problem for people who want to make lifetime transfers of business interests while retaining control of the assets transferred.

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Eleventh Circuit upholds LIFO loophole.

Regular "C" corporations with LIFO (Last-In, First-Out) inventories that elect to become S corporations generally must recapture the excess of the current cost of the inventories over the LIFO value, called the LIFO reserve as income on the final C corporation income tax return.

Coggin Automotive Corporation was a holding company with six subsidiary corporation automobile dealerships. The automobile dealerships were restructured as limited partnerships, and Coggin elected to become an S corporation. The group had LIFO reserves of about $5 million. Coggin claimed that, since it didn't own the inventories directly, no recapture was required.

The IRS disagreed with Coggin. The Tax Court agreed with the IRS. The Eleventh Circuit Court of Appeals overruled the Tax Court.

This may be a temporary planning opportunity for regular corporations who want to convert to S corporations but have big LIFO reserves. The IRS may try to appeal the decision to the Supreme Court. Alternatively, Congress will probably eventually close the loophole.

If you decide to try this technique, be sure to work with a tax attorney who has carefully studied this case. (Coggin Automotive Corporation v. Commissioner, CA 11 6/6/2002.)

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Taxpayer may not deduct ex-spouse's attorney fees as alimony.

The Tenth Circuit Court of Appeals affirmed a Tax Court ruling that a taxpayer who paid legal fees incurred by his ex-spouse in divorce proceedings was not entitled to deduct the fees as alimony. The debt was a fixed amount and, in order to be deductible as alimony, the obligation would have to terminate at the death of the ex-spouse. (Berry v. Commissioner, 10th Circuit, 6/6/02.)

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"Last Chance" for Retirement Plan GUST amendments.

The IRS has issued new guidelines to help retirement plan sponsors avoid disqualification for failure to make timely amendments for retirement plan law changes during the 1990s called "GUST." The under the new procedures, a plan sponsor may apply for a determination letter by September 3, 2002. Previously, the changes had to be in place by February 28, 2002. (Rev. Proc. 2002-35.)

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Qualified plans must be amended for new minimum distribution rules.

Qualified plans must be amended by the last day of the first plan year starting on or after January 1, 2003 to comply with final and temporary minimum distribution regulations recently issued by the IRS. (Rev. Proc. 2002-29.)

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IRS issues new Net Operating Loss carryback form.

The IRS has updated Form 1045 (Application for Tentative Refund) and instructions to include the new five-year net operating loss carryback period enacted as part of the Job Creation and Worker Assistance Act of 2002. It has also issued a supplement to IRS Publication Number 536, explaining the new NOL rules.

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Employee equipment rental arrangements must meet accountable plan requirements.

The IRS has revoked Revenue Ruling 68-624, which many employers had relied upon to exclude payments to employees for equipment rental from wages. According to the IRS, rental payments must meet the requirements for an accountable plan in order to be accounted for separately from wages. The employee must substantiate the actual expenses he or she is being reimbursed for, instead of being reimbursed at a flat hourly rate with no accounting made. (Revenue Ruling 2002-35.)

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All Federal S Corporations are also California S Corporations.

As part of the conformity legislation recently passed by California, effective January 1, 2002, all corporations with a valid federal S election will also be taxed as S corporations in California. Previously, a corporation could elect to be be taxed as a C corporation in California but an S corporation on its federal income tax return.

According to Spidell's California Taxletter, a fiscal year corporation will have to file two short-period returns, because the law states the change takes place on January 1, 2002.

In addition to shareholders becoming subject to California income tax on their California-source S corporation income, former California C corporations could have additional tax liabilities relating to the Built-In Gains Tax and LIFO reserve recapture, and could lose the benefit of net operating loss carryovers and tax credit carryovers incurred as a C corporation.

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Questions and Answers

Question

I plan to use the deemed sales election in 2001 to create gains to offset against some AMT credits for 2000. Have you seen anything from the IRS arguing against this position?

Answer

No. There are a number of tax benefits that you can get from making the election and this is one of them.

Question

I just started a cleaning business and I only have a couple of clients right now. I didn't need much money to get started. What amount should I be reinvesting in the business? I currently have a SMALL cushion of funds put away for cleaning supplies, etc.

Answer

There is no set percentage or amount. Be sure you have set aside enough cash to pay your income taxes. Then project what your requirements are for expanding your business. Remember, there can be big jumps in your cash requirements when you require a business location and when you start hiring employees.

It sounds like you are starting very small, but you should still be seeking advice. Consider consulting with an enrolled agent.

Question

I am negotiating to purchase a 2002 40 foot motorhoome. I live in Illinois. Is there a luxury tax on motorhomes in Illinois?

Answer

There is no federal luxury tax for motorhomes.

I don't practice in Illinois. The best way for you to get your answer is to call a dealer for new motorhomes in Illinois.

Question

Is there any change regarding the 24-month occupancy rule to get the $250,000/$500,000 exclusion for sale of a principal residence? If you buy a more expensive home, does the exemption really matter?

Answer

There is no change, except the IRS has issued regulations explaining the exclusion. You may qualify for a partial exclusion if you have to move before meeting the requirements if you have to sell the home because of a change in employment.

It no longer makes any difference if you buy a more expensive home after you sell your home. Those old rules were repealed when the $250,000/$500,000 exclusions were enacted.

Question

I left California in September, 2000 to move to Australia for 1 year. My accountant tells me that I owe $2,275 in California tax because California doesn't exclude foreign income. Is there a way to legally avoid this, since I didn't live in California?

Answer

You have stumbled into one of the most complex areas of California tax law. Your accountant is probably right. California residents, even when they temporarily leave the state, are subject to tax on their worldwide income. In order to avoid California tax, you would have to demonstrate that your intention was to not return to California and show you severed your ties to the state. That's hard to do when you left for such a brief period of time.

Question

My father recently passed away and left the life insurance and 401(k) money to his wife of 9 months. She is going to distribute the money to each of his sons. Do we have to pay taxes on the money she gives us. (About $35,000 each.)

Answer

Oregon has an inheritance tax. I don't have the details about it, so I suggest you consult with a local CPA.

I hope your stepmother is getting legal and tax advice. She should be considering making a disclaimer for her inheritance to avoid being subject to income tax on the 401(k) funds and having the amounts given to you and your brother(s) subject to gift tax.

If she files the disclaimer on time, you and your brother(s) will be subject to income tax on the 401(k) funds that you receive.

Based on the information you gave me, I can't tell whether your father's estate is subject to estate tax. Your stepmother should also consult with an attorney and tax advisor to find out.

Question

I understand it's more beneficial to make IRA contributions at the beginning of the tax year because the income is compounded and deferred for a longer time. What about SEP IRAs? Can self-employed persons make those contributions based on estimated income at the beginning of the year and adjust them after actual net income is computed?

Answer

Yes, but it can be complicated to compute the correct amount to withdraw if the contribution was too large. I had a situation recently with a taxpayer who is filing a late income tax return, and the income from his business was less than originally estimated. This would be a real pickle if he made a contribution based on the initial estimate.

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Michael Gray regrets he can no longer personally answer email questions. He will answer selected questions in this newsletter.

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Can we save you mortgage dollars?

For over a year, we have been helping existing clients reduce their interest rates, finance home remodeling and finance building new homes through our mortgage brokerage business. Now we can extend this service to readers of this newsletter who live in California. We specialize in no cost, no fee refinancing. (No cost, no fee refinancing is not available for home purchases, deferred interest or loans under $175,000.) Through our strategic partner, Wymac Capital, Inc., we can offer very competitive rates through a range of lenders. We also have a "rate watch" service to notify you when the rates have fallen enough for you to benefit from refinancing. For a complimentary, no-obligation mortgage consultation, please call Mike Gray at 408-918-3161.

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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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• "How To Win Friends & Influence People" Book Review

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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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P.P.S.

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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.