Michael Gray, CPA's Tax and Business Insight

April 2, 2004

© 2004 by Michael C. Gray

ISSN 1539-395X

A monthly report to help you prepare for your financial future, keep more of what you earn by minimizing your taxes, and build an extraordinary business!

Route to _______   _______   _______   _______   _______

(If you find this information valuable, please pass it on to a friend!)

Table of Contents

• An announcement from "soon to be Grandpa" Mike.
• Happy holidays.
• Extensions - when you don't have the money to pay the tax.
• First individual estimated tax payment is due April 15.
• Questions and Answers
  • Where do I report income from 1099-MISC forms?
  • Can I choose which residence to claim an exemption for?
  • How do I figure the right number of exemptions to claim?
  • Do I qualify as a full-time student?
  • Can I claim my grandparents as dependents?
  • Should there be withholding when I sell a rental home?
  • Can I file as head-of-household for my parents?
  • How can I reduce the taxable income from selling my house?
  • Do I have to file a tax return for my California rental property?
• Do you have employee stock options?
• PS Marché Aux Fleurs
• Subscribe/Unsubscribe from Michael Gray, CPA's Tax & Business Insight

An announcement from "soon to be Grandpa" Mike.

Yes. We have been keeping a secret under threat of death, but finally have permission to reveal it to the world. My daughter, Holly, and her husband Dan Baker are expecting a child, probably next September. This will be the first grandchild for my wife, Janet, and me. Of course we are thrilled!

Return to Table of Contents

Happy holidays.

With the activity of tax season, it can be easy to forget that spring holidays are upon us. Whatever your beliefs, we wish you happiness in celebrating with your family.

Return to Table of Contents

Extensions - and when you don't have the money to pay the tax.

(This is a reprint from past newsletters.)

What do you do when you don't have the money to pay the tax?

My first recommendation is to file your income tax returns, certified mail, by the initial filing date. One of the nastiest penalties in the IRS's arsenal is for late filing - 5% per month to a maximum of 25%. Some people who owe money don't file their returns because they are afraid. THIS IS A HUGE MISTAKE! The best approach is to be honest about your situation and work with the tax authorities to resolve it.

When your file an extension, any balance of tax due when the tax return is filed represents an exposure for the late filing penalty.

Please don't misunderstand me. I regularly use extensions for my clients and myself as a workload "safety valve". We often don't have the information to complete a return by the due date. They just aren't appropriate when there will be a significant balance due that won't be paid by the original filing due date.

According to the Treasury regulations for the requirements to file a valid automatic extension request, "an application for extension must show the full amount properly estimated as tax for the taxable year." (Reg. § 1.6081-4(a)(4).) The regulations relating to reasonable cause for failure to file a tax return state that if a taxpayer satisfies the requirement of showing the full amount estimated as tax, the taxpayer has a reasonable cause for failure to file during the extension period provided (1) the excess of the amount of tax shown on the return over the amount of tax paid by the original filing date (including the amount paid with the extension form) is no greater than 10 percent of the amount shown on the return (restated - 90% of the tax is paid by the due date), and (2) any balance due shown on the return is paid with the return. (Reg. § 301.6651-1(c)(3).)

(For California taxpayers, the extension is paperless so the amount of the tax need not be stated. You are still required to pay at least 90% of the tax by the original due date to avoid the late filing penalty.)

If you have filed an income tax return for 2002, you can process your federal extension electronically or by telephone - call 888-796-1074 by April 15. Better call early to beat the rush! Mailing a paper form is still acceptable and is the only way a person who didn't file a 2002 income tax return can request an automatic extension.

A taxpayer can still avoid the late filing penalty by demonstrating a "reasonable cause," but this can be a hassle and the taxpayer is at the mercy of the subjective judgment of a representative of the tax authority.

Remember you may now pay income taxes using a credit card. Call 800-272-9829, or try the web site, www.officialpayments.com. The extension for California is 1555. You can also call 888-729-1040. Maybe you can find a card offering a low interest rate promotion that will work for your situation.

Should you borrow using a margin account? In most cases, this is not a good choice because of the exposure to margin calls if the market declines.

Should you use an equity advance loan, secured by your principal residence? In some cases it might be to your advantage, if you can get a favorable interest rate. Remember interest for an equity loan not used for a home improvement is only deductible on a loan amount up to $100,000. This interest is not deductible when computing the alternative minimum tax.

Remember that IRA accounts and even other retirement accounts can be temporary sources of funds. Distributions from IRAs that aren't minimum required distributions can be rolled over to another IRA or returned to the same IRA within 60 days after a withdrawal. This exception only applies to one rollover per year. (You must wait more than one year after a rollover is completed before making another one.)¹

Certain distributions from other qualified plans can also be rolled over within a 60-day period to an IRA or another qualified plan.² Using IRAs or qualified plans as a temporary source of funds to pay taxes can be useful if the funds to complete the rollover will soon be available, such as when there is a lockout "window" that will soon be open. The cost of an error can be high, because if the rollover isn't completed before 60 days have expired, the distribution may be subject to tax as ordinary income plus a 10% early distribution penalty.³

The IRS has a form for installment agreements, Form 9465. They would prefer that you submit the form with your income tax return. You can take up to five years to pay off your tax liability. An advantage of arranging an installment agreement is the penalty for late payment of tax is reduced from 1/2% per month to 1/4% per month. In addition to penalties, interest is charged for late tax payments. The interest rate is adjusted quarterly. Recently, the rate has been five percent.

Another alternative is to make an Offer in Compromise, Form 656. With this procedure, the IRS actually can reduce your tax based on your ability to pay. You don't have to wait until you have owed the tax a long time to use this procedure. I think it's best to work with an attorney, CPA or enrolled agent when making an Offer in Compromise. If the amount is large, an attorney is probably the best choice.

Although it may provide relief from your other creditors, bankruptcy doesn't offer much help for recent debts for income taxes. When you make payments on your tax bill, be sure to specify to apply the payments to taxes due. Penalties and interest are dischargeable in bankruptcy, but income taxes aren't.

It may be to your advantage to plan how to use regular tax or alternative minimum tax capital loss carryovers or minimum tax credit carryovers. You might need to generate capital gains, which can be difficult when you're in financial distress.

Return to Table of Contents

First individual estimated tax payment is due April 15.

(This is a reprint from past newsletters.)

Remember to review your estimated tax situation for 2004.

There is no estimated tax penalty provided the taxpayer pays at least 90% of the tax (including AMT) on the current year's tax return through withholding and/or equal quarterly estimated tax payments.

For taxpayers who have no more than $150,000 of adjusted gross income ($75,000 for married persons, filing separately) on the previous year's income tax return, there is no penalty for underpayment of estimated tax provided at least the income tax on the previous year's income tax return (including AMT) is paid in equal quarterly estimated tax payments plus withholding.⁴ For taxpayers who have more than $150,000 of adjusted gross income ($75,000 for married persons, filing separately) on the previous year's income tax return, there is no penalty for underpayment of estimated tax provided at least, for 2003, 110% of the income tax on the previous year's income tax return (including AMT) is paid in equal quarterly estimated tax payments plus withholding.⁵

Taxpayers who have uneven income and deductions may also compute their estimated tax on an "annualized" basis. You multiply the year to date income and deductions to arrive at amounts for a year, compute the tax for that amount, then pay amounts to cumulatively pay in 1/4, 1/2, 3/4 and 100% of those amounts. You should probably get help from a professional tax return preparer to do this.

Return to Table of Contents

---

Questions and Answers

Question

I work in computer sales for a PC components distributor. I have received two 1099-MISC forms -- one from a vendor who gives us commission money in the form of cash, the other from a vendor on whose website I had won prizes/awards that exceed $600. Where do I report the income from these 1099 forms?

Answer

The commissions should probably be reported on Schedule C. As an "independent contractor" receiving commissions, you are considered to have a trade or business. The prizes should be reported as "other income" on line 21 of Form 1040.

Question

If you sell two residences that qualify for the principal residence exclusion within a two-year period and the profit from the first sale is small, can you just pay tax on the capital gain from the first sale and claim the exemption from the second?

Answer

Yes.

Question

I recently bought a house and want to change the exemptions for my withholding. Currently, I am claiming single 0, but I am married. How do I figure the correct number of exemptions to claim?

Answer

There is a worksheet for Form W-4 (the withholding form) that outlines a method for computing the correct number of exemptions to claim. Try using the worksheet. You might need to seek help with this from a tax advisor.

Question

At the beginning of each semester, I was considered a full-time student. During the mid-point, I dropped classes. Do I have to be enrolled full-time for the entire semester to be considered a full-time student for my parents to claim me as a dependent?

Answer

It appears to me to be based on the facts for a month-to-month basis. You must have been enrolled as a full-time student for five months during the taxable year to meet the full-time student exception for ages 19 to 23.

Do yourself and your parents a favor. Stick with your studies and finish those classes. Time is passing, and "time is money"!

Question

My grandparents live with us 9 months out of the year. When they live with us, we provide all of their living requirements or support. They do not contribute to our household expenses. They manage an RV park for three months, for which they have W-2 income of $1,900 each, and have Social Security income. Can we claim them as dependents?

Answer

Yes. Tax exempt Social Security payments are not counted for the income limitation. Your grandparents do not have enough income for their Social Security to be taxable. You are providing more than one-half of their support, and they meet the relationship test. Remember, they can't claim their own exemptions if you claim them.

Question

My friend just sold his rental property and had to pay withholding for capital gains taxes. I thought taxes were just paid when you filed your income taxes, and he really didn't make much.

Answer

California is collecting withholding for real estate sales to help with the budget mess. Your friend should show the withholding as a tax payment on his or her California income tax return to recover any tax withheld over the actual amount owed.

Question

I live in my parents' home with my son. My father passed away this past year and they had no income except for social security, a small IRA that my mother cashed out to pay for funeral expenses and W-2 income of $1,800. I help my mother with most expenses. Can I file as head of household and claim one or both of my parents as dependents?

Answer

Since you are living in your parents' home, I don't think you can qualify as a head of household. With the IRA, it looks like your mother has too much income for you to claim her as a dependent. You would have to provide more than one-half of your father's support to claim him as a dependent. You could only claim him as a dependent if his income tax return is filed on a married, filing separately basis.

Question

My wife and I have lived in our home as our principal residence for six years and are now selling it for a net gain of $690,000. Are there any methods to avoid Federal and California tax consequences on the $190,000 in excess of the $500,000 exclusion?

Answer

The $190,000 is a taxable long-term capital gain. Remember the federal tax rate for this will only be 15%. If you have any investments that you can sell for capital losses, sell them this year and offset the losses against the taxable gain.

Question

I live in Illinois and my mother died, leaving me some rental property in California. I made a profit of $4,000 last year. Do I have to file a tax return for California? How do I do it? Where do we get the forms?

Answer

You are required to file Form 540NR. You can find the forms at www.ftb.ca.gov. When income is taxable in two states, you get a state tax credit, usually on the income tax return for your resident state. Consider getting help with your income tax returns for this issue.

---

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

Return to Table of Contents

If you have employee stock options, have you subscribed to Michael Gray, CPA's Option Alert?

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

Return to Table of Contents

P.S.

My daughter and her husband, Holly and Dan Baker, have 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 and their website address is www.marcheauxfleursrestaurant.com. For the best meal of your life, call 415-925-9200 for a reservation and give them a try! For directions, visit our website at www.taxtrimmers.com/directions.shtml.

Return to Table of Contents

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.

Return to Table of Contents

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.

---

1 Internal Revenue Code § 408(c)(3)
2 Internal Revenue Code § 402(c)
3 Internal Revenue Code § 72(t)
4 Internal Revenue Code § 6654(d)(1)
5 Internal Revenue Code § 6654(d)(1)(C)