Michael Gray, CPA's Tax and Business Insight

November 7, 2005

© 2005 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!

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Table of Contents

• Happy Thanksgiving!
• It's time for year-end planning.
• Thanksgiving celebration call-in day.
• Tax Reform Panel Report - dead on arrival?
• Domestic production deduction guidelines issued.
• Sales tax deduction set to expire.
• Social security wage base for 2006.
• Tool allowance explained.
• New retirement plan limits released.
• Disregarded entities to pay own employment and excise taxes.
• Questions and Answers
  • Do we have to pay taxes on a gift from my parents?
  • What happens if we sell our home before living there 2 years?
  • Are personal injury settlements taxable?
  • Is there a penalty for selling a home in less than 2 years?
  • What happens if you over-contribute to a Roth IRA?
  • Can I 1031 exchange a condo and move into the replacement property?
• Do you have employee stock options?
• Read our new article!
• PS Marché Aux Fleurs
• Subscribe/Unsubscribe from Michael Gray, CPA's Tax & Business Insight

Happy Thanksgiving!

November is a month to remember our blessings. I am thankful to have a business located an eight-minute walk from my home and a ground-floor office with a garden view. I am thankful that my daughter, Dawn, works with me three days a week and looks after our web site and internet communications with tender, loving care. We have a beautiful and enthusiastic worker in Thi Nguyen. We have great clients that other CPAs would kill for.

Thanks, again for your business, and your support of our CPA firm. There would be no newsletter without our clients' support, so you readers who aren't currently clients should also give thanks to our clients.

I am thankful for a great family, including Janet, my darling wife for the last 33 years; both of my parents are still gamely living; my children Dawn, Holly and James and son-in-law Dan (who really makes mealtime a joyous occasion!) Janet and I are thrilled to baby sit our one year old grandson, Kyan, on Saturday nights. So many more blessings, but it's time to move on with the newsletter.

Be sure to count yours. It's great for your health and your peace of mind. And they say being thankful for your blessings attracts more into your life. Maybe that's why we celebrate Thanksgiving.

We at Michael Gray, CPA hope you and your family have a safe and happy Thanksgiving, with all the trimmings!

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It's time for year-end planning.

Less than two months left in the year, and they are the two busiest and seem like the shortest months of the year. Considering the holidays, the times available for year-end planning consultations will be limited. Why not call for your appointment now?

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Thanksgiving celebration call-in day.

As a client and reader appreciation event, we will have a call-in day on Tuesday, November 22. You may call in for a 10-minute "consult" at no charge. For advance preparation, you may fax information in advance to 408-998-2766. The calls will be handled on a first-come, first-served basis. We will not return calls at no charge for which messages are left during these times. If we don't answer, try calling again until we are connected.

In such a short period, we will be unable to answer complex questions requiring research. Be reasonable with your expectations.

The telephone number is 408-918-3161.

From 9 a.m. to 10 a.m. PST, we will take calls only from clients who have paid us for services during 2005.

From 10 a.m. to noon PST, we will take calls from clients and readers of our newsletters.

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Tax Reform Panel Report - dead on arrival?

The President's Advisory Panel on Federal Tax Reform issued a 272-page report on Monday, November 1. The panel is wrestling with a very difficult problem. By 2013, less revenue would be lost by repealing the regular tax than the by repealing the alternative minimum tax. President Bush asked the Panel to develop alternatives to make our tax code simpler, fairer and more conducive to economic growth, while recognizing the importance of home ownership and charity in American society.

The panel developed two alternatives. One is called the Simplified Income Tax Plan and the other is called the Growth and Investment Tax Plan. Having two alternatives makes it more confusing to discuss the proposals.

The provision most discussed in the press is the reduction of the benefit for the home mortgage deduction. The home mortgage deduction would be replaced with a tax credit equal to 15% of interest paid for a mortgage, limited to the average regional price of housing - about $227,000 to $412,000. It's proposed the change would be phased in over a five-year period. It's obvious this provision will severely hurt taxpayers who recently bought homes in high cost areas like here in Silicon Valley, where "starter homes" cost about $750,000.

The proposals go farther than that. The itemized deduction schedule would be eliminated. The deductions for state income taxes and property taxes would be eliminated. The casualty loss deduction and deductions for miscellaneous itemized deductions like employee business expenses would be eliminated. Special deductible Save For Family accounts, like health savings accounts, would be created to replace the medical deduction and provide for education needs. Medical insurance would be deductible up to limitation amounts (about $5,000 for an individual and $11,500 for a family.)

Charitable contributions would be deductible for all taxpayers for amounts paid over 1% of income. Taxpayers could sell non-cash assets tax-free when the proceeds are donated to a charity within 60 days after a sale. Charities would be required to issue information returns for donations with a value over $600. Taxpayers would no longer be able to rely on "do it yourself" receipts to value charitable contributions. The Panel recommends the status of different types of charities should be re-examined to determine whether they should qualify as charities for tax-deductible donations.

The alternative minimum tax would be repealed. (With all of the base-broadening, the regular tax will look much more like the alternative minimum tax looks now.)

Under the Simiplified Income Tax Plan, there would be four tax brackets with a maximum tax bracket of 33%. Under the Growth and Investment Tax Plan, there would be three tax brackets. with a maximum tax bracket of 30%.

Under the Growth and Investment Tax Plan, investment in business-use land, building and equipment could be expensed, but business interest wouldn't be deductible, except for banks. The tax rate for dividends, taxable interest and long-term capital gains would be 15%. (The tax situation for real estate investors would be radically changed, with reliance on debt financing discouraged.)

There are many more details that I don't have space to discuss. This is a very difficult problem. Every tax benefit or deduction has a group that sees it as a "sacred cow". If we are going to keep the current system but eliminate the alternative minimum tax, income tax rates will probably have to be raised. With current and projected federal deficits, tax rates may be forced up in any case.

This report should initiate debates in Congress about how best to reform our tax system. Many of us believe it should be reformed, but disagree about what our tax system should look like. From the comments in the press, it appears Congress isn't embracing the proposals, and, as a lame-duck President facing many challenges, President Bush probably doesn't have enough influence to push this proposal through Congress in its current form.

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Domestic production deduction guidelines issued.

The IRS has issued proposed regulations explaining the new deduction for domestic production activities. The deduction does not apply for service businesses, but does apply to sales, leases and licensing of property manufactured, produced, grown or extracted by a taxpayer in whole or in significant part within the U.S.

The deduction equals the lesser of (a) a percentage of the smaller of (1) the qualified production activities income of the taxpayer for the year or (2) taxable income (or modified adjusted gross income, for individual taxpayers) without regard to the manufacturing deduction for the tax year. The percentage is 3% for tax years beginning in 2005 and 2006, 6% for tax years beginning in 2007-2009, and 9% thereafter; (b) 50% of W-2 wages of the employer for the tax year.

If this deduction applies to you, consult with your tax advisor about these new regulations under Internal Revenue Code Section 199.

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Sales tax deduction set to expire.

Remember the election to deduct sales taxes instead of state income taxes is scheduled to expire after 2005. It was only effective for 2004 and 2005. Therefore, consider whether it would be to your tax advantage to make a large purchase before the end of this year. (For states with high income tax rates like California, the state income tax deduction will usually be bigger than the sales tax deduction.)

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Social security wage base for 2006.

The Social Security Administration has announced the social security wage base for 2006 will increase to $94,200 from $90,000 for 2005. The rate of tax is 6.2% for employees and employers, and 12.4% for self-employed persons.

Medicare wages have no ceiling and the Medicare tax rate remains at 1.45% for employees and employers, and 2.9% for self-employed persons. (Social Security news release 10/14/05.)

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Tool allowances explained.

The IRS has issued 2005-52, clarifying whether tool allowances paid to employees should be treated as wages, subject to employment taxes. In order to avoid treatment as wages, employer payments to the employee must be made under an accountable plan. Employees must substantiate the expenses reimbursed. If the employer makes advance payments to employees for these expenses, any payments exceeding the actual amount must be reimbursed to the employer. Estimates may not be used to substantiate the expenses. The IRS is considering negotiating industry-wide guidelines through the Industry Issue Resolution Program. (Rev. Rul. 2005-52.)

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New retirement plan limits released.

The IRS has released cost of living adjustments for retirement plan contributions for 2006. The maximum annual benefit for a defined benefit plan has been increased from $170,000 to $175,000. The maximum contribution for defined contribution plans (profit sharing, money purchase pension, ESOPs) has been increased from $42,000 to $44,000. The maximum catch-up contribution for individuals age 50 or over has been increased from $4,000 to $5,000. The annual compensation limit has been increased from $210,000 to $220,000. The limit for elective deferrals (401(k)) has been increased from $14,000 to $15,000. The maximum catch-up contribution for individuals age 50 or over for 401(k) plans has been increased from $2,000 to $2,500. (IR-2005-120.)

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Disregarded entities to pay own employment and excise taxes.

The IRS has issued proposed regulations that will change reporting of employment and excise taxes for disregarded entities, like qualified subchapter S subsidiaries (QSubs) and single-owner LLCs. These entities are treated as transparent for income tax reporting and their income and deductions are reported on the income tax returns of their parent or owner. In the past, the owner entity could report and pay the subsidiary's employment and excise taxes (Notice 99-6). Now the IRS is proposing these disregarded entities should file returns and make tax payments for employment taxes separately.

The IRS says it is having difficulty administering the employment and excise tax laws for the disregarded entities. For example, the disregarded entity might be doing business in a different state from its parent.

The new rules would be effective on January 1 following the date the regulations are published as final regulations. (Prop. Reg. § 1.1361-4(a); Prop. Reg. § 301.7701-2(e).)

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Questions and Answers

Dear readers:

Many of your questions relate to the sale of a principal residence. We have an article at our web site, "Could your residence be the ultimate tax shelter?" (http://www.taxtrimmers.com/residence.shtml) where you should be able to find the answers to most of these questions.

Question

Do we have to pay taxes on a gift of $100,000 from my parents for our first home? Do my parents have to pay tax on it?

Answer

Gifts from family members aren't taxable income for income tax reporting. There is a federal gift tax system. Gifts of cash exceeding $11,000 per donor, per donee, per year are exempt from gift tax. For example, your parents can give a total of $44,000 to you and your spouse in one year and not be subject to tax. Gifts exceeding the exempt amount are taxable, but eligible for offset by an allowance of $1 million per individual.

In short, your parents should report the gifts to you and your spouse on gift tax returns, Form 709, for 2005. They probably will not have to pay any cash out of pocket for the gifts, but their lifetime exclusions will be applied. They should consider getting help from a tax return preparer.

Question

My husband and I bought our home in June 2004. We are thinking about relocating to be closer to our families. We would both be able to transfer and keep our current jobs. What are the tax consequences of selling the home before living there for more than two years?

Answer

You probably would not qualify for the exclusion of up to $500,000. Look at the details of your situation. After commissions and selling expenses, you might not have much gain to be concerned about.

Question

A friend of mine received a settlement from a lawsuit relating to an injury to her foot and leg at work.

The settlement was $75,000. The attorney will receive his fees, and Medicaid will be reimbursed for about $3,000.

Is the award taxable? Her attorney never mentioned anything to her about taxes.

I know there are laws excluding settlements and awards for personal injuries. Does she have to figure out how much was for being out of work, doctor bills, etc.? How can she do this?

Answer

The education and background of personal injury lawyers usually isn't focused on tax law. They have a different area of practice. Meanwhile, the claims filed and settlement agreement can have major tax consequences.

There is a tax concept called "the origin of the claim". If the settlement is for a tax-exempt matter, such as physical injury, the settlement received should be exempt from tax. Punitive damages are not tax exempt. An amount paid from physical injury that is exempt can go beyond medical expenses, because of the loss of potential earning power and so forth as a result of the physical injury.

I suggest that your friend meet with a tax consultant to discuss the details of his or her case and determine the tax consequences. The entire award might be tax exempt.

Question

I have lived in a single-family home for 19 months. Is there a penalty if I sell the home before I have lived in it for more than two years?

Answer

In order to qualify for the $250,000 per individual exclusion for sale of a principal residence, you must live in the home for more than two years. Sometimes you can get a prorated exclusion if the home must be sold early for unforeseen circumstances. Maybe you can just hold on for five more months?

Question

What happens if you contribute more to a Roth than the limitation amount?

Answer

A non-deductible 6% excise tax is imposed on excess contributions to a Roth for each year until the excess amount plus related earnings are distributed. (Internal Revenue Code Section 4973(a).)

Question

Prior to marriage, I owned a condo that I occupied. My husband and I moved into a single family home. The condo's been rented now for about 15 years. If I sell the condo and 1031 exchange it, can I ever occupy the property I exchange to?

We would like to retire in 2-3 years, so we would like to rent the condo until retirement. Then we would like to sell our home and move into the exchanged property.

Can we do this?

Answer

I think the transaction should be adequately "seasoned" after two or three years of renting it out, so you can probably do this.

There are no firm rules about this situation. If the property you are receiving isn't deemed to be "investment property" but "personal use property", the exchange doesn't qualify. The IRS could raise this argument in an audit.

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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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• Public Speaking and Influencing Men In Business book review

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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 http://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 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.