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Table of Contents

• The half-way mark.
• Extended income tax returns almost due!
• Mark your calendars for these presentations by Michael Gray.
• We can track mortgage rates for you.
• Bookkeeper accused of embezzling $11 million.
• IRS announces new procedure for EINs.
• Sale of right to future lottery payments results in ordinary income.
• IRS finds weakness in armor of family limited partnerships.
• Governor Davis's proposals would raise California taxes.
• California Franchise Tax Board loses Supreme Court ruling.
• Questions and Answers
  • What is the definition of a "Primary Residence"?
  • Does luxury tax apply to a car I won?
  • How can I show my margin loan isn't for my house?
  • How soon can I convert a rental property to a primary residence?
  • How do capital gains rules apply to real estate?
  • Can I withdraw SEP-IRA money to purchase a home?
• Do you have employee stock options?
• PS Marché Aux Fleurs
• Visit our new articles
• Subscribe/Unsubscribe from Michael Gray, CPA's Tax & Business Insight

Hope you and yours had a happy Independence Day!

The half-way mark.

This year is already half over! How is your year going?

With the improvement in the stock market, we are seeing some clients for tax planning that we haven't for a while. Should you be one of them?

The new tax law has some dramatic changes for the taxation of investments that may suggest some repositioning. There are also some important changes for businesses. Shouldn't you get a preview of how your tax situation will change?

Call Michael Gray at 408-918-3161 today to make your appointment.

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Extended income tax returns almost due!

The due date based on the initial extension request for calendar year individual income tax returns is August 15, 2003. (That's less than a month and a half from now!) If you have filed an extension, please send us the information to finish your income tax returns as soon as possible.

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CPAs, Attorneys and Financial Advisors, mark your calendars for these presentations by Michael Gray.

On August 27, 2003 at 7:30 a.m., Michael Gray will join a panel of CPAs discussing the Jobs and Growth Tax Relief Reconciliation Act of 2003 for the Silicon Valley-San Jose CPAs. The two-hour presentation will conclude at 11 a.m. The location is Lou's Village in San Jose. The advance reservation investment is $40 for members of the California Society of CPAs and $50 for non-members. For details and reservations, call Valerie Bishop at 408-983-1122.

On September 17, 2003 at 11:45 a.m., Michael Gray and Carol Zolla, Esq. will make a one-hour "brown bag" presentation about Handling Retirement Accounts After A Death for the Silicon Valley Bar Association. The location is the Santa Clara County Superior Court. The advance reservation investment is $15 for members and $20 for non-members. For details and reservations, call Jim Griffiths at 650-325-7808.

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We can track mortgage rates for you, so you don't have to.

Interest rates continue to fall. This is still a great time to refinance, whether to get cash for remodeling your home, to finance a new business, to buy your dream yacht, or to just save interest dollars.

At no charge or obligation, we can track your home mortgage and notify you when refinancing is to your advantage.

Remember, we offer home mortgages as a service to our clients and newsletter subscribers located in California through our strategic partner, Wymac Capital. We specialize in financing with no points and no costs, if certain conditions are met.

To find out if we can reduce your home mortgage costs or help provide financing for education, home improvements, a vacation, or a new home, please call Michael Gray at 408-918-3161. There is no fee or obligation for this service.

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Bookkeeper accused of embezzling $11 million from Los Altos resident.

As reported on the front page of the July 3, 2003 San Jose Mercury, Carol Ann Huang has been accused of embezzling $11 million from Edward Scarff, a former Transamerica executive. This appears to be another case of "no one was looking." Ms. Huang apparently forged Mr. Scharff's name on several documents, including applications for lines of credit, and had signature authority for several of his accounts. With today's accounting software, staff people have been eliminated that once provided internal controls in organizations. Banks no longer require financial statement audits for small businesses, and audits have never been widely performed for individuals.

This case is a reminder that internal control checks and the use of internal and external auditors are important when there is a lack of segregated duties in handling the finances of a business or a substantial individual. Getting a fidelity bond for individuals in positions of trust can also be a wise investment. Compilation or review financial statements and tax return preparation aren't as rigorous as an audit. A new class of auditors is also developing that specializes in fraud-busting as opposed to giving opinions on financial statements.

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IRS announces new procedure for EINs.

The IRS has developed a new way to take the frustration out of getting an employer identification number for a business, estate or trust. The application can now be made at the IRS web site, and the number will be issued almost instantly. Tax return preparers can apply on behalf of their clients. The preparer is required to keep a signed copy of Form SS-4, including a statement authorizing the representative to receive the number online. (IR-2003-77.)

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Sale of right to future lottery payments results in ordinary income.

The Tax Court ruled that a sale of part of a $15 million lottery prize in 1992 resulted in ordinary income. The taxpayer claimed the prize was a capital asset and the income should be taxed as a capital gain. (David K. Simpson, et ux. V. Commissioner, T.C. Memo. 2003-155.)

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IRS finds weakness in armor of family limited partnerships.

Family limited partnerships are a very popular and powerful tool for achieving valuation reductions in making asset transfers for family estate and business planning. The IRS has recently enjoyed success in attacking valuation discounts for family limited partnership interests under Internal Revenue Code Section 2036 -- transfers with retained life estate. In these cases, the transfers are usually made shortly before death and distributions aren't made according to the partnership percentage interest. The taxpayers who lost these cases were "pushing the envelope" in the tax benefits claimed. In order to get the estate benefits from these arrangements, it's essential for the partnership transactions to be documented and the partnership should be operated properly. (Estate of Strangi v. Commissioner, T.C. Memo 2003-145.)

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Governor Davis's proposals would raise California taxes.

California's budget for the next fiscal year is far from settled. The Republicans have sworn not to raise taxes and are pushing for the recall of Governor Davis.

Governor Davis's proposal to deal with California's deficit is to borrow the money and repay it with increased taxes. The revenue would come from (1) suspending the Teacher Retention Credit for 2003; (2) increasing the California sales tax by 1/2 percent, effective October 1, 2003; (3) creating at 10.3% top individual tax rate for joint filers with taxable income of more than $300,000 and single filers with taxable income over $150,000; (4) increasing the cigarette tax by 23¢ a pack, effective July 1, 2003; and (3) tripling vehicle license fees. Budget bills in the Senate and Assembly would require that tax return preparers who prepared more than 100 individual income tax returns last calendar year to efile their clients income tax returns or pay a $50 per return penalty for failure to efile.

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California Franchise Tax Board loses Supreme Court ruling.

Gil Hyatt, a resident of Nevada and former resident of California disputed the tactics used by the California Franchise Tax Board in asserting claims against Mr. Hyatt for California tax. Mr. Hyatt sued the Franchise Tax Board for tort claims in Nevada court. The Franchise Tax Board claimed the Nevada court didn't have jurisdiction in this case. The U.S. Supreme Court ruled Nevada does have jurisdiction, thus permitting Mr. Hyatt to continue his case in Nevada. (Franchise Tax Board v. Gilbert P. Hyatt (2003) 538 U.S.___(Docket No. 02-42.))

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Questions and Answers

Question

I own a home in Oregon. I lived there for 1.5 years. I just moved to California, and want to streamline refinance through FHA my home in Oregon.

What is the definition of a "Primary Residence?" Since I was living in the home for at least half of the year, does this still qualify? Or would the Oregon residence no longer be my primary residence?

Answer

From a tax point of view, your primary residence is determined by where you live and work. It appears to me the Oregon residence won't qualify. Try asking the person who will assist you in processing the loan.

Question

I won a $50,000 car in a drawing that I entered at the mall. Does the luxury tax apply?

Answer

No. The luxury tax expired, effective January 1, 2003.

Question

I understand using a margin loan to purchase a home would result in non-deductible interest expense. I intend to sell some stock to purchase a new home. Is there a certain amount of time that I need to wait before taking out a future margin loan to buy stocks so the IRS will not deem the new loan to have been for the house?

Answer

No. Complex tracing rules apply to margin loans. As long as the loan proceeds can be traced to investments that aren't tax exempt (and those investments aren't then sold and the proceeds used for personal purposes), the interest expense should qualify as investment interest expense. Note it will be more difficult to claim investment interest expense under the new tax law. Dividends taxed at the 15% capital gains rate are not investment income.

Question

I'm making a 1031 exchange with a rental house. How soon can I convert the replacement property to my primary residence without disqualifying the exchange?

Answer

There are no solid guidelines on this issue. I would suggest that you wait at least a year, preferably two.

Question

A mortgage client doesn't want to buy a home and sell it in less than two years because he thinks the capital gains tax will be too great. How do the capital gains rules apply to real estate?

Answer

The rules for real estate are the same as for other capital assets, except for the exclusion when selling a principal residence. When the property is held more than one year before it is sold, the gain will be a long-term capital gain, eligible for the 15% maximum federal tax rate. Very rarely will a transaction result in a tax exceeding the income received, so thinking "the tax is too high" usually isn't a valid argument against going ahead. There may be other personal reasons for not going ahead that your client isn't telling you.

Question

My employer puts money into SEP-IRA accounts for its employees. Can I take some of the money out of my account without a penalty? I am trying to buy my first home and need some help with the down payment.

Answer

There is an exception to early withdrawal penalties for distributions from an IRA to buy a principal residence. Only $10,000 may be withdrawn for this purpose during an individual's lifetime. To qualify, the taxpayer must be considered a "first-time homebuyer." To be a first time homebuyer, the individual (and spouse, if married) must not have had an ownership interest in a principal residence during the two-year period ending on the date that the new home is acquired.

The exception is reported at line 2, Part I of Form 5329.

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

To subscribe, go to www.stockoptionadvisors.com. You can review our last issue at www.stockoptionadvisors.com/optionalert/news.shtml.

Advisors may find information about joining the Employee Stock Option Advisors Association, LLC and training materials about tax planning for employee stock options at www.stockoptionadvisors.com/seminar.shtml.

Employee option holders may find information about self-study materials relating to planning for employee stock options at www.stockoptionadvisors.com/seminar.shtml.

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Visit our new articles!

• "Opportunities Can Be Traps"
• Twenty Ads That Shook The World 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 taxtrimmers.com/directions.shtml.

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P.P.S.

To receive the next issue of Michael Gray, CPA's Tax & Business Insight with more tax developments, another book review, and upcoming deadlines automatically via email, subscribe by filling out the form below.

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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.