Married filing jointly with taxable income of $200,000
Save $100 for 10% bracket change
Save $1,122 on 15% bracket changes
Save $2,864 from rate reductions
Total savings = $4,086
Example 3 (p. 1-6)
Head of household with taxable income of $50,000
Save $239 from rate reductions
15% Maximum Tax On:
Dividends through 2008
Personal Holding Company Income and Accumulated Earnings Tax
Marriage Penalty Relief
Accelerates 15% tax bracket expansion for 2003 and 2004 to scheduled 2008 levels instead of phasing them in over four years beginning in 2005
15% bracket for married joint return to twice the single level
Example Marriage Penalty Relief (p. 1-8)
Married couple each with taxable income of $28,400 or $56,800 together
Prior to Act the marriage penalty = $1,122 (includes rate reduction of 2%)
After Act the marriage penalty = $0
Maximum taxed at 15% under old law$47,450; now $56,800
Taxpayers with taxable income greater than $47,450 will benefit
Also benefits married taxpayers filing separately
Acceleration of Increase in Standard Deduction
Accelerates standard deduction increase for 2003 and 2004 to scheduled 2009 levels instead of phasing them in over five years beginning in 2005
Married filing separately is one-half the joint return amount – NOT the inflation adjusted amount from prior law
2003/2004 Standard deduction = $9,500 ($4,750 X 2)
Reduce/eliminate mortgage interest deduction for many taxpayers
Reduce benefit of capital losses against ordinary income
Accelerated Increase in Child (<17) Tax Credit
From $600 to $1,000 for 2003/2004
Refundable to extent of 10% of the taxpayers earned income in excess of $10,500
Increases to 15% in 2005
For families with three or more children, it is refundable to extent social security taxes exceed the earned income credit, if greater than 10% earned income > $10,500.
Example Child Credit (p. 1-12)
Still phased out above $75,000 single and $110,000 joint returns at $50 for each $1,000 above limits
Married filing jointly two children Modified AGI of $135,000
Old rules no child credit (25 x $50 = $1,250 reduction)
New rules = credit of $750
Increased child tax credit amount paid in advance – based on 2002 tax return and expected 2003 eligibility.
Joint return-one child still eligible $400
Joint return-two children in 2002, only one eligible in 2003 $400
Tax Credits Allowed in 2003 Reduced by Advance Payments
Example 1 received $400 and will have a $600 ($1,000 - $400) credit if still qualified.
Example 2 received $400 and will also have a $600 credit if still qualified.
Given past history-the advance payment will NOT have to be repaid if they are not eligible for the child tax credit.
IRS Procedures for Advance Payments
Notices sent to taxpayers on amount of advance payment, number of children used to determine, whether limited due to phase-out or tax liability or earned income limits.
New worksheet in 1040 package to determine credit (One of the top 10 errors on 2001 returns!)
5-year carryback extended through 2005
May offset 100% of AMTI through 2005
Increased emphasis on CG since the 5% drop in CG is greater than the 3.6%/2% change in regular tax rates
Spread between top individual rates and CG rate increased.
Reduced taxes on sale of luxury homes with gain in excess of the exclusion limits
Older clients should evaluate whether to sell appreciated assets and invest proceeds in dividend paying stock.
Consider gifting assets to children over age 13 to get lower rate – 5% now and 0% in 2008.
Repeal of Five-Year Gain Property
18%/8% rates for >5 year property repealed
§1202 also requires a five-year holding period to exclude gain
Capital Gains Rates 8% 8% 18% LT gain >60 months in 2009 10% 15% 20% Lt gain >12 months in 2009 0% 0% 15% LT gain in 2008 5% 5% 15% LT gain prior to 2008 10% 15% 28% Collectible/§1202 gain 10% 15% >15% Type Gain - Taxpayer Bracket
Pass-Through Entities and CG
Recognition date determined at the entity level
What about when an owner sells his interest prior to an actual capital gain by the entity if the per share per day rule is used and the books are not closed?
Example 8 (p. 1-20) – S Corporation
$100,000 CG July ($200,000 x 50%)
50% shareholder sold entire interest March 31 st
$25,000 post May 5 th gain allocated to him and he gets a lower CG tax rate
Capital Gains Complexity
8 new lines added to Schedule D, Schedule D Tax Worksheet, Form 6251 – AMT, and Form 8801 – AMT credit
Column (g) of Schedule D revised for amounts after May 5 and worksheet for 28% gains that was in column (g)
Luckily, 1040 software will reduce the computational complexity for preparers.
Form 1099-DIV will have to be revised for dividends after May 5 also.
Taxpayers with only CG distributions will need to file Form 1040 and Schedule D – NOT use the 1040 worksheet and Form 1040A to get lower rates.
Payments received after May 5, 2003 and before 2009 eligible for new rates.
If part of the gain is 25% gain – it is taxed first.
15% rate may not apply immediately.
Installment sales should be structured to maximize the use of the new rates.
Plan for sunset or extension
Can sell or modify terms to recognize gain
Can transfer to taxpayer in lower brackets and get 0% in 2008, if gift prior to 2008
Dividend Tax Relief For Individuals
2003-2008 Dividends taxed at same rates as capital gains, but effective for entire year.
Applies to both common and preferred dividends
Does NOT apply to 401(k) plans and IRA’s
Gives new emphasis to taxable investments vs. tax exempt investments
Planning Tip - Investors with both taxable and tax-deferred accounts may want to reallocate investments to put interest earning ones into tax-deferred and ones that earn dividends into taxable accounts.
Qualified Dividend Income
Domestic and qualified foreign corporation
Does not include foreign personal holding companies, foreign
investment companies, and passive foreign investment companies
Holding period – less than 60 days during 120 days prior to ex-dividend date (PF stock is 90 of 180 days)
Extraordinary dividend is qualifying, but if stock sold at loss, the loss is treated a long-term capital loss to extent of dividend.
Dividends if taxpayer is obligated to make related payments on similar or related property (i.e., short sale)
Any amount taken into investment income to support an investment interest deduction
Dividends from tax exempt corporation
Deducted under §591 by Mutual Savings Banks
Paid on ESOP’s
Example of Impact of New Rules
Unmarried taxpayer salary = $80,000
CG - $12,000
Dividends = $8,000
Old law tax = $21,888
New law tax = $19,082
Tax savings = $2,806
Change in rates will put more emphasis on dividends and not as much emphasis on stock buy-backs.
Stock buy-backs still will produce less income since basis will reduce the gain (p. 1-32).
Dividends – Distributions of property from Earnings & Profits
Current E&P first, then Accumulated E&P
Example 1 (p. 1-41)
Dividends = $10,000
Return of capital then capital gain for remainder of distribution
Example 2 (p. 1-42)
Accumulated E&P ($200,000)
Current E&P $100,000
$100,000 distributed in quarterly payments – all dividends
If distribution was following year, then $0 dividend if no current E&P in 2004.
Taxation of Corporate Distribution to Shareholder
Amount received plus fair market value of property less any liability assumed. Fair market value cannot be less than liability assumed.
Three Tier Taxing System
Dividends to extent of E&P
Reduction of basis
Gain from sale of property
Basis of property is fair market value
Corporation must recognize gain on appreciated property distributed.
Allocation of E&P To Distributions
Current E&P first – Both current gains and losses must be prorated if distributions in excess of current E&P.
Accumulated E&P in chronological order if distributions exceed current E&P.
Penalty Taxes #1 Accumulated Earnings tax
Assumes tax avoidance
15% tax rate now (38.6% under old law) on:
$250,000 ($150,000 for personal service companies) OR
Reasonable business needs
Holding and investing company limited to $250,000
Based on economic concept of income (similar to E&P)
Penalty Taxes #2 Personal-Holding Company Tax
Personal Holding Company
At least 60% AGI from dividends, interest, royalties, annuities, rents, oil & gas, etc.
>50% of stock owned by 5 or fewer
Assumes tax avoidance
15% tax rate now (38.6% under old law)
Distributions for S Corporation with Accumulated E&P (p. 1-51)
Nontaxable return of capital to extent of Accumulated Adjustments Account (AAA) (Tax-free to extent of S/H’s basis in S Corp. Stock)
Dividend from E&P
Return of capital
Gain on sale or exchange
May make election to bypass AAA and go directly to E&P
§179 Expensing Election
Tax years beginning after 2002 and before 2006
$100,000 – up from $25,000
Dollar Limitation - $400,000 (phased out as before for excess)
After 2003, the limits will be indexed for inflation.
Taxable income limit still applies.
Added off-the-shelf software to §179 property
May revoke §179 election without IRS consent, but decision is irrevocable after made
§179 reduces E&P ratably over 5 years
Special Depreciation For Certain Property
2002 Act allows additional 30% depreciation for property purchased after 9-10-2001 and before 9-11-2004
Must meet four requirements
Classes of property
Original use property
Acquired during the allowed period
Placed-in-service date (one year extension for 10-year or longer property and certain transportation property)
Additional $4,600 for first year of “luxury” automobiles – Total first year $7,660
Could elect out of additional depreciation
New Bonus Depreciation
50% for property placed in service after May 5, 2003 and before January 1, 2005 (2006 for certain property as before)
Applies to tax years ending after May 5, 2003
Additional $7,650 for first year of “luxury” automobiles – Total first year $10,710
May elect 30%, 50%, or none
Fiscal-year pass-through entity will recognize bonus depreciation at end of fiscal year – may not show up until 2004
Basis is adjusted to reflect additional depreciation & §179
Applies for both regular tax and AMT
Property Acquired in 2003
May be eligible for:
30%, 50%, §179 at $100,000, or §179 at $24,000 (or some combination of these)
$200,000 purchase on July 1 – entitled to both 50% and §179 at $100,000
$200,000 May 1 – §179, but only 30%, not 50%
$200,000 on July 1 for 9-30 year-end taxpayer – 50%, but §179 at only $24,000
Mid-quarter convention applies, but §179 amounts reduce the amount placed in service for this calculation.
Increased First-Year Depreciation for Luxury Automobiles
Incidental does NOT include laundry, cleaning, telephone, lodging taxes, etc.
Individual Taxation – 4
Net unearned income of a child
Earned income credit
Earned income by the credit amount
Phase-out based on AGI
AGI disregards net capital losses, net losses from trusts and estates, net losses from nonbusiness rents and royalties, and 50% of net losses from businesses.
Exclusion of income for redemption of U.S. savings bonds, but phased-out over a $30,000 range.
Individual Taxation – 5
Social security adjustments
Wages base is $87,000 for OASDI.
$11,520 earnings level for ages 62 to 65 for cutback of social security benefits. No cutback age 65 or older.
Hope credit – maximum is $1,500 (100% of first $1,000 and 50% of next $1,000) and phased-out between $83,000-$103,000 joint and $41,000-$51,000 single
Lifetime learning credit – Maximum is $2,000 (20% of up to $10,000)
Individual Taxation – 6
Student loan interest
Phased-out based on MAGI
Coverdell Education Savings – 1
$2,000 contribution; not a deduction
Grows tax free until distributed
Child under age 18
Phased-out based on MAGI
Funds can be used to pay K-12 costs
Coverdell Education Savings – 2
Anyone may make contributions
Entity contributions permitted
Deadline April 15
Reverse excess funding by June 1
CES withdrawal and Hope/LLC in same year allowed
May contribute to both CES and §529 plans
§529 Plans - 1
Two types of plans
Tax-free if spent on higher education
2004 for private institutions/no 10% penalty until then
Sponsorship by educational institutions
Excess distribution §72 applies – Proportionate income
Hope or L.L. credits OK in year of §529 plan withdrawal
Rollover to other plans tax-free
OK to fund CES in same year
First cousins now included as family
10% penalty on income portion of excess withdrawal, except for:
Death and disability
Special needs beneficiary expenses
Completed gift in year of contribution
Room and board now “reasonable expenses” instead of dollar limit
5 years of annual gift exclusions may be used by special election
§529 Plans - 2
Questions About §529 Plans?
2001ARD 247-3 Congressional Research Service Report – 12/17/01
May move between plans once per year
Relationship between §529 plans and student financial aid
Pension Limits - 2003
Defined-benefit plan limit - $160,000
Annual addition limit - $40,000
Elective deferral limit - $12,000
Maximum catch-up - $2,000 ($1,000 for SIMPLE §401(k))
SEP compensation cap - $200,000
Highly compensated employees - $90,000
SIMPLE maximum deferral - $8,000 ($1,000 maximum catch-up)
SEP minimum compensation level - $450
IRA - $3,000 (catch-up $500)
Dependent Care Credit & Exclusion
Maximum expense allowed
$3,000 for one child
$6,000 for two or more
35% maximum credit
20% minimum credit
Phase-down between $15,000 and $43,001 of AGI at a rate of 1% for each $2,000
Dependent care exclusion limited to $5,000
Miscellaneous Individual Provisions
Medical insurance deduction for self-employed taxpayers at 100%.
Qualified long-term care deduction increased (depends on age).
Medical savings accounts have been extended (again) and with higher deductibles.
Foreign earned income exclusion - $80,000
110% safe harbor for estimated taxes for high income taxpayers (>$150,000)
Deduction for education expenses - $3,000 ($4,000 in 2004)
Family Cases – 1 (p. 2-23)
Bonus payments not deductible as alimony
Ninth Circuit – individual’s obligation to make bonus payments under divorce decree not subject to termination on death was NOT alimony (Fithian v. United States).
Innocent-spouse relief for nonrequesting spouse
Rev. Proc. 2003-19 effective after April 1, 2003 and prior to this if no preliminary determination was issued – a nonrequesting spouse may now file a written protest and receive an appeals conference on decision to grant any relief to requesting spouse.
Family Cases – 2 (p. 2-24/25)
No innocent-spouse relief
Spouse knew of some, but not all of unreported income (Dalton v. Commissioner, T.C. Memo 2002-268).
Equitable relief granted by Tax Court when denied by the Service (Washington v. Commissioner, 120 T.C. No. 9, 2003).
Income Cases - 1
Compensation or Gift?
Taxpayer received Form W-2 with base salary, but did not include bonus.
Corporation did not withhold income or employment taxes from bonus, but deducted it as salary expense.
Taxpayer argued that they were gifts from the corporation due to her being friends with the President.
Decision - They were compensation and was subject to accuracy-related penalty. (Williams v. Commissioner, T.C. Memo. 2003-97)
Income Cases – 2
Disability insurance policy to cover loans
Received some payments under this policy
Insurance company decided that he was not entitled to payments made, but that repayment would not be possible and sent a 1099 MISC.
Taxpayer did not include discharge in income.
He argued that it was not income since he did not receive the 1099-MISC.
Decision - Discharge of debt was income. (Violette v. Commissioner, T.C. Summary Opinion 2002-149)
Income Cases – 3
Taxpayer received annual payment plus interest on divorce settlement, but did not report the interest.
Settlement called for payments plus interest at 5.5%.
Taxpayer argued that the interest was post-divorce appreciation of her former spouse’s law practice and was not taxable.
Decision - Court held that it was interest & that attorney fees were not deductible. Cipriano v. Commissioner, No. 02-1055 (3 rd Cir. 2003), aff’g T.C. Memo 2001-157)
Income Cases – 4
Return preparer (Stupidity or Greed?) (Group discussion pp. 2-30/31)
Preparer did not report income from his return-preparation activity and his taxable social security payments.
IRS asked for records of bank accounts and he did not provide them.
IRS sent questionnaires to clients about fees and estimated his income.
Decision - ? (Joseph v Commissioner, T.C. Memo 2003-19)
Income Cases – 5
District manager of insurance company received commission on sales in the district.
Insurance company terminated agreement and gave him a termination settlement based on length of service and last six months earnings.
Taxpayer treated payments as gain from sale of insurance agency (franchise).
Decision - Tax Court held that payments were ordinary income and subject to self-employment tax. (Parker v Commissioner, T.C. Memo. 2002-305)
Income Cases – 6
Taxpayers received income from fishing activity without any withholding by boat owners.
They argued that income was not taxable since the boat owners should have withheld the taxes.
Decision - Tax Court held that gross receipts were taxable regardless of whether the boat owner had properly withheld taxes. (Goins v. Commissioner, T.C. Memo. 1997-521, aff’d, 4 th Cir. 1998)
Income Cases – 7
Assignment of Income I
In 2001 Service allowed leave-based donation program without applying assignment-of-income doctrine. In 2003, they will apply it. (Notice 2003-1)
Assignment of Income II
Donating appreciated stock can provide double benefit:
Deduction at fair market value
Exclusion of gain
Service may apply assignment-of-income doctrine if sale is complete PRIOR to the donation.
They tried to apply it to a case where the taxpayer knew the sale was imminent, but not complete.
Decision - Tax Court held for the taxpayer. (Rauenhorst v. Commissioner, 119 T.C. No. 9 (2002)
Income Cases – 8
Taxpayer argued that the lottery winnings was a property interest and produced a capital gain when sold.
Decision - Tax Court held it was ordinary income. (Boehme v. Commissioner, T.C. Memo. 2003-81)
Exclusion for redemption of U.S. Savings bonds used to pay higher education expenses.
Taxpayer failed to show that expenses were paid in the year that bonds were redeemed.
Decision - Exclusion denied by Tax Court. (Medina v. Commissioner, T.C. Summary Opinion 2003-115)
Deductions Cases – 1
Charitable deductions to ministry disallowed
Taxpayers were “ministers” of Alpha Ministries and claimed charitable deductions for amounts used to pay personal expenses.
Decision - Court disallowed deductions and impose20% accuracy-related penalty for negligence. (Smith v. Commissioner, T.C. Summary Opinion 2003-16)
Who is minister of the gospel?
Teachers and administrative staff of a school that is an affiliate of a church are not “ministers of the gospel” and not entitled to exclusion of housing allowance.
Their duties did not include duties performed by Christian ministers (Lord’s supper, baptism, marriage, moderating of church sessions, conducting worship services, performing funeral services, ministering to sick and needy). (TAM 200318002 )
Deductions Cases – 2
Taxpayer must maintain adequate records.
Taxpayer did not have records.
Court followed Cohan rule to establish a small deduction for clothing donations, but disallowed a claimed cash deduction and one for a paving stripping machine, they claimed was given to the Church to complete a parking lot repavement project, due to lack of documentation. (Cameron v. Commissioner, T.C. Summary Opinion 2002-4)
Deductions Cases – 3
Home interest disallowed since taxpayer failed to secure the loan with his personal residence. (Boehme v. Commissioner, T.C. Memo. 2003-810
Margin interest – Tax court held that taxpayer may deduct margin interest paid on brokerage account trades as investment interest. (Miner v. Commissioner, T.C. Memo. 2003-39)
Taxpayer replaced roof on rental house due to leaks and expensed it.
IRS claimed it should be a capital expenditure.
Decision - Tax Court allowed the deduction since it merely restored the rental to a previous condition (leak free roof). (Campbell v. Commissioner, T.C. Summary Opinion 2002-117)
Deductions Cases – 4
Taxpayer made improvements on lease – some in lieu of rent.
Taxpayer deducted all improvements.
Service ruled that they must capitalize improvements.
Decision - Court held that payments in lieu of rent could be deducted and others must be capitalized. (McGrath v. Commissioner, T.C. Memo. 2002-231)
Deductions Cases – 5
Home Office I
Taxpayer was full-time freelance writer and received payment when work completed and some royalty and residual income, but he was considered an employee in the industry.
Home office met exclusive use test, regularly used, was the principal place of business, and was for the convenience of the employer.
He had an office in his home and two rental apartments in which he worked and was entitled to limited deductions for home office and business expenses.
Deductible expenses could not exceed gross income from writing.
Income from writing did not include residuals. (Radnitz v. Commissioner, T.C. Summary Opinion 2003-29)
Deductions Cases – 6
Home Office II
Self-employed interior decorator rented an apartment and used part for an office.
He purchased computer equipment and software and included their cost in cost of goods sold on his Schedule C.
Taxpayers did not attach Form 4562 and made no indication they were claiming a §179 expense.
Service disallowed some home office deductions based on the income limitations and disallowed the deduction for the computer equipment and software in total, but did allow depreciation.
Decision - §179 is not allowed retroactively. (Visin v. Commissioner, T.C. Memo. 2003-246)
Deductions Cases – 7
Taxpayer claimed dance expenses of 14 year old daughter were in connection to profit as a manager of entertainment and sports clients.
He had had not been paid by anyone he represented and did not have an agreement for future earnings.
Daughter had many years training and won many contests.
He and his daughter had a management contract.
Decision - Court held all were personal expenses since he seemed to be in parental activity versus an activity for profit. (Carino v. Commissioner, T.C. Summary Opinion 2002-140)
Deductions Cases – 8
Deducted payments to wife by insurance company to pay for care – NOT allowed since not paid by him and if they had been it was long-term care, not medical.
Van expense in excess of car expense to haul scooter – NOT allowed since not essential to medical care.
Dependent care expenses for disabled son while traveling – NOT allowed due to personal nature and lack of substantiation.
Electrical generator to backup electricity since son very distressed when radio, television, air conditioning not operating – NOT deductible as medical expense.
Maintenance of swimming pool used for rehab – Allowed even without actual receipts.
Expenses of sending son to special camp – Allowed. (Emanual v. Commissioner, T.C. Summary Opinion 2002-127)
Deductions Cases – 9
§1244 Loss on small-business stock
Not allowed since it was ruled as not being an operating company. (Crigler v. Commissioner, T.C. Memo. 2003-93)
Rental activity subject to passive-loss limitations (Group Discussion – pp. 2-48/51)
Taxpayers had five apartments & three single family condominiums they rented.
Taxpayer was Engineer & wife an Accountant who worked 1,800 hours. She also actively managed rentals. Later she quit work to manage rentals full-time.
They did not elect to treat all rentals as one activity. She made general notes on her calendar on rental activities.
Deducted losses on Schedule E based on her assertion that she was a Real Estate Professional.
Decision - ?
(Jahina v. Commissioner, T.C. Summary Opinion 2002-150)
Capital Transactions – 1
Taxpayer traded water rights for fee simple interest in land and treated it as a like-kind exchange.
Decision - Court held that is was not a like-kind exchange. (Wiechens v. United States; No. CIV 00-1858-PHX-SMM (D. Ariz. 2002)
Loss on sale of former home (Group Discussion-pp. 2-52/53)
Taxpayer owned home and couldn’t make payments so he leased it for a short period and then sold it the next year.
He deducted the loss as a capital loss.
Service disallowed since he did not provide proof of cost in excess of selling price and, alternately, that the transaction was not entered into for profit.
Decision - ? (Abrams v. Commissioner, T.C. Summary Opinion 2002-155)
Capital Transactions – 2
Revocation of an election out of installment reporting
Election must be made by due date – any revocation is retroactive.
Taxpayer inadvertently revoked installment method when his accountant overlooked it and included all the gain on sale and he signed the return.
Service allowed revocation of election (PLR 200305014).
Taxpayer had to file amended return.
Similar ruling in PLR 200308042.
Foreclosure proceeds used to pay real estate taxes includable in capital gain calculation even though proceeds went directly to county treasurer for taxes. (Jokinen v. Commissioner, [not for publication] (11 th Cir. 2002)
Transfer Tax Cases – 1
2003 transfer tax limitations
$11,000 annual gift exclusion
$345,800 applicable credit ($1,000,000 estate)
2004 the gift tax stays the same
2004 – Estate tax credit is $555,800 ($1,500,000 estate)
$112,000 gift tax exclusion for non-U.S. citizen
$840,000 – Maximum reduction for special use value
$1,120,000 – Maximum value for deferral of estate tax payment for closely held business
$1,120,000 – Exemption for generation skipping tax
$7,700 – qualified funeral trust
25% of State death tax credit that was allowed pre-2001
Transfer Tax Cases – 2
Estate tax rates
Present interest in gifts of entity interests
Must be present interest.
Taxpayers formed LLC to manage tree farm for long-term income.
Court ruled no present interest and therefore no gift eligible for annual exclusion. (Hacki v. Commissioner, 7 th Cir. 2003, aff’g 118 T.C. 279 (2002)
Transfer Tax Cases – 3
Estate tax valuation of family limited partnership interests – Underlying assets may be measure of value.
They were successful where partnership had marketable stock and securities.
Commingling of funds
Unilateral nature of formation without adequate consideration (Estate of Harper v. Commissioner, T.C. Memo 2002-121)
Another Tax Court case required inclusion of family limited partnership interests in gross estate valued at underlying assets transferred.
Decedent held enjoyment of assets.
Principal economic beneficiary
None of the beneficiaries participated in business. (Estate of Thompson v. Commissioner, T.C. Memo 2002-246)
Strangi v. Commissioner (T.C. Memo 2003-145) had same results. Biggest difference was that decedent had ability to transfer assets, actual economic benefit NOT required.
Substantially Equal Periodic Payments – 1
10% penalty for early withdrawal of the taxable amount unless an exception, one of which is substantially equal periodic payments. If the owner changes the method before age 59 ½ the penalty is retroactive to all payments.
Example 1 – TP payments begin at age 53. Age 57 withdrew balance of account. She is liable for 10% penalty on all payments.
Substantially equal payments prior to age 59 ½ must generally continue for at least 5 years or they are subject to 10% penalty.
Example 2 – TP started withdrawals at age 57. Four years later she withdrew the balance. Liable for 10% penalty on the payments received PRIOR to age 59 ½.
Substantially Equal Periodic Payments – 2
Prohibition on change within five years is not applicable if due to death or disability.
Example 3 – TP needs to withdraw balance four years later since she is disabled. No 10% penalty is due for any amounts received.
Substantially equal payments – 3 approaches recognized by IRS:
Life Expectancy method – Required minimum distribution based on IRA owner or joint life expectancy of IRA owner and designated beneficiary.
Amortization method – Balance evenly over life expectancy as above.
Annuity method – Balance by an annuity factor using reasonable mortality table and reasonable interest rate.
Substantially Equal Periodic Payments – 3
Example – TP is 50 year old woman with no designated beneficiary.
Life expectancy method – Using formula with a deemed life expectancy of 43.5 years and a $105,000 balance = $2,370.20 distribution (recalculated each year).
Amortization - $100,000 balance with 8% amortization over life of 33.1 years = $8,679 distribution each year.
Annuity - $100,000 with interest at 8% the mortality table gives a factor of 11.109 = $9,002 distribution each year.
The owner must receive the EXACT amount.
Exceptions apply to EACH IRA, not the aggregate.
If taxpayer chooses the amortization or annuity method, they may change to the required minimum distribution method at any time.
The new method is required in all subsequent periods and is not considered a change in method.
Substantially Equal Periodic Payments – 4
Divorcing taxpayer – Payment changes made subject to a QDRO in a divorce is not considered a change.
Distributions from qualified plan subject to additional tax
Taxpayer retired at age 52 and rolled pension plan into IRA.
Calculated minimum distributions based on a 29 percent growth rate and used the amortization method.
Court held it was not a reasonable growth rate and distributions were subject to 10% penalty. (Farley v. Commissioner, T.C. Summary Opinion 2003-43)
Substantially Equal Periodic Payments – 5
Withdrawal from qualified retirement plan subject to additional tax – Taxpayer withdrew money to pay for higher education expenses and asked IRS help line if she had to pay the tax. They told her that she was not subject to penalty tax.
Taxpayer could not substantiate that she was eligible for inclusion of room and board (1/2 time student). She continued full-time employment as a nurse.
She withdrew money one year and spent it over two years (less than distribution).
Decision - Only amounts spent for education in year of withdrawal was exempt from the tax. (Dunn v. Commissioner, T.C. Summary Opinion 2002-108)
Substantially Equal Periodic Payments – 6
Early IRA distribution beyond $10,000 for first house was subject to 10% penalty. (Tussey v. Commissioner, T.C. Summary Opinion 2003-47)
Rollover of plan proceeds into rental property (held NOT to be a retirement plan) subject to tax on early distribution. (Beneventi v. Commissioner, T.C. Summary Opinion 2003-13)
Taxation of beneficiary of a qualified employee benefit plan – Lump-sum distribution of employer stock into another qualified plan does not bar an employee from excluding net unrealized appreciation on stock distribution in kind. (PLR 200243052)
Substantially Equal Periodic Payments – 7
IRA distribution includable in gross income. (Group Discussion – pp. 2-75/76)
Taxpayer withdrew IRA and put in nonqualified annuity and did not include amount in gross income.
IRS contacted and taxpayer had bank try to correct by making it a qualified annuity and labeled it a bank error and they back dated the document.
A year later the actual funds were still in same nonqualified account.
Decision - ? (Crow v. Commissioner, T.C. Memo. 2002-178)
Retirement Plans - 1
§401(k) contribution limits
$12,000 – 2003 and increasing $1,000 a year until it reaches $15,000 in 2006 and then adjusted for inflation.
Catch-up elective deferrals are $2,000 in 2003 and increasing $1,000 a year until they reach $5,000 in 2006.
These limits are applied to the individual.
Retirement Plans – 2
Maximum contribution is $40,000 or 25% of employee’s compensation.
6% excise tax on excess contributions
SIMPLE plan contributions
Salary reduction contribution and
Employer matching contributions (up to 3%) OR
Employer nonelective contribution (2% if employee earns at least $5,000 with a maximum of $4,000 contribution)
$8,000 maximum and increasing $1,000 year until it reaches $10,000
Catch-up is $1,000 and increasing $500 a year until $2,500 in 2006
New IRAs – Deemed IRA & new $3,000 limit
Principal Residence Regulations - 1
What is a residence?
If more than one, which one is the principal residence?
Generally, the one used the majority of the time.
Can vacant land be a principal residence? Probably, if adjacent and used as part of residence.
Ownership and use – two years of last five. Do not have to be the same two years nor does it have to be concurrent years.
Short temporary absences OK.
Only one year use required if physically or mentally incapable if self-care.
Principal Residence Regulations - 2
Depreciation – Exclusion does not include gain on sale that is attributable to depreciation after May 6, 1997. Any gain is §1250 unrecaptured gain at 25% tax rate.
Property used in part as a principal residence and part for other purposes – No allocation is required if residential and nonresidential portions are within the same dwelling unit. The exclusion would apply to the entire sale except any possible §1250 unrecaptured gain for depreciation taken.
If the nonresidential portion is not in the same dwelling unit, a prorata allocation of the sale and basis must be made to determine the gain. The exclusion is only for the residential portion.
Principal Residence Regulations - 3
Maximum exclusion - $250,000 single & $500,000 joint
Either spouse can meet ownership requirements.
Both spouses must meet use test.
Neither spouse excluded gain in last two years. (Sale or exchange prior to May 7, 1997, is disregarded.)
Reduced maximum exclusion – Prorata amount of maximum exclusion if less than 2 years due to:
Changes of employment
Natural disasters, death, etc.
Principal Residence Regulations - 4
Multiple Residences, e.g., “Snow Birds”
Cases and Rulings - Business Chapter 3
S Corporations - 1
Couple not entitled to deduct losses from S Corporation
Taxpayers formed corporation, but did not file Forms SS-4 or 2553 for S Corporation status.
Filed tax return on Schedule E and Service advised them to file Form 1120.
After deficiency notice, accountant had them file an amended return and move the business to Schedule C.
Decision - Court disallowed all losses due to lack of substantiation and ruled they were C Corporation since they did not file as required. (Highbee v. Commissioner, T.C. Summary Opinion 2002-128)
S Corporations – 2
(Group discussion-p. 3-2/3)
Taxpayer owned part of S Corporation that operated bowling alleys.
Taxpayer purchased equipment individually and leased to S Corporation since they couldn’t get financing.
Deducted losses from lease on Schedule E and argued that lease was not a rental since it was provided to his business.
Service ruled that it was a rental and subject to passive loss rules. (“Duck” theory)
Decision - ?
Would could the TP done differently so the loss would be allowed? (Sciabica v. Commissioner, T.C. Summary Opinion 2002-146)
S Corporations – 3
Passive-investment income in general
S Corporation had E&P and invested in 3 publicly traded partnerships that met the requirements to be partnerships for tax purposes.
Was the nature of the income from these partnerships passive or not?
Decision - Gross receipts were not converted to passive income upon allocation to S Corporation. The character of the receipts for Taxpayer is the same as the character of the receipts to the partnership. (PLR 200309021)
S Corporations – 4
S Corporation rental income not passive – two separate rulings
S Corporation provided significant services and incurred substantial costs in connection with commercial property leases.
Decision - They were a trade or business. (PLRs 200252036 & 200252037)
S Corporation pass-through items are not self-employment income and losses cannot offset other self-employment income. ( Ding v. Commissioner, 9 th Cir. 1999, aff’g 1997-435 T.C. Memo)
S Corporations – 5
Form of doing business
Shareholders paid back taxes for partnerships that were 60% owned by S Corporation.
They deducted 100% of payments.
Payments were treated as capital contributions to S Corporation and then by S Corporation to partnerships.
60% of expenses by partnerships were then pass-through to S Corporation. (Griffin v. Commissioner, T.C. Memo. 2002-6)
S Corporations – 6
C Corporation was a member of partnerships that used LIFO.
C Corporations restructured and elected S Corporation status.
Decision - Required to include prorata share of partnership inventories in gross income as its ratable share of LIFO recapture amount. (Coggin Automotive Group v. Commissioner, 115 T.C. 349 (2000)
S Corporations – 7
Recent IRS statistics prove S Corporation are the most popular choice of entity (1999).
2,700,000 – S Corporations
889,000 – Partnerships
589,000 – LLCs
354,000 – Limited partnerships
42,000 – LLPs
1,071 - REITs
Discharge of Indebtedness
Discharge of indebtedness income does not flow through to the shareholders to allow losses after October 11, 2001
Law change to overrule the Supreme Court in the Gitlitz case.
S Corporations – 8
ESOP distribution does not jeopardize S corporation status.
S Corporation stock may be held by ESOP, but not by IRA.
Taxpayer may want to rollover account into IRA.
Service issued Rev. Proc. 2003-23 that sets forth requirements to allow this.
S Corporation must immediately repurchase stock from IRA simultaneously with the direct rollover distribution and no distributions of any kind are attributed to the IRA.
S-Corporation Planning Tip
Corporate tax rates not reduced
Small business owners should still tale advantage of S-Corporation election.
Partnerships – 1
Option to acquire partnership interest coupled with distribution was a disguised sale.
Taxpayer formed partnership with two affiliates that granted an option to acquire an interest from an unrelated party.
Unrelated party contributed exercise price equal to taxpayer’s prior contributions less distributions to taxpayer.
Decision - Service ruled a disguised sale. (TAM 20030104)
Group restructuring into pass-through entities
Service revised earlier ruling that now makes this partially taxable as a liquidation and partially tax-free. (PLR 200310026 revising PLR 200252014)
Partnerships – 2
Final regulations on partnership basis adjustments under §705:
Issued to prevent inappropriate increases or decreases in the adjusted basis of a corporate partner’s interest resulting from the partnership’s disposition of the corporate partner’s stock.
The increase or decrease in the corporation’s adjusted basis is the amount of gain/loss that they would have recognized (without application of §1032) if a §754 election had been in effect.
Service efforts to match Schedule K-1 forms to tax returns (renewed K-1 matching program)
C Corporations – 1
Taxpayer operated commercial logging business.
Endangered Species (Mexican Spotted Owl) discovered and logging halted.
Taxpayer deducted value of covenants-not-to-compete.
Decision - Court allowed deduction (Covenant was worthless). (Precision Pine & Timber, Inc. v. Commissioner, T.C. Summary Opinion 2003-19)
Payment of shareholder personal expenses is nondeductible by corporation. (Pigs get fat; hogs get slaughtered.) (Group discussion-p. 3-17)
Decision-? (Dobbe v. Commissioner, (9 th Cir. 2003) [not for publication], aff’g T.C. Memo 2000-330)
C Corporations – 2
Loan to gas station corporation
Corporation ran station/convenience stores.
Made deal with AMOCO for products.
AMOCO agreed to provide equipment and services and payments would be deemed paid if dealer supply agreement still in effect.
Note called for payments and interest.
Taxpayer guaranteed indebtedness to AMOCO.
Corporation recorded note as deferred income on books and Form 1120.
Service ruled that full amount was income when received.
Decision - Court held it was a loan. (Erickson Post Acquisitions, Inc. v. Commissioner, T.C. Memo 2003-218)
Methods of Accounting – 1
Deferral of advance payments
To reduce litigation over whether payments are for services, nonservices, or a combination, the Service issued a proposed procedure that expands the scope of the deferral rules to include advance payments for some nonservices and mixed service/nonservices. Allows deferral to next year if same deferral for financial reporting purposes. (Rev. Proc. 2002-79)
Methods of Accounting – 2
Service’s position on changes in accounting method:
Change in method usually over four years unless <$25,000.
Now positive adjustments over four years and negative adjustments in year of change.
Change in method allowed prospectively, but without audit protection, if the method is an issue pending for a tax year under examination or an issue under consideration by an appeals office or a federal court. (Rev. Procs. 2002-9, 2002-19, 2002-54)
Methods of Accounting – Cases & Rulings – 1
Taxpayer manufactured and sold items and systems directly to customer.
Contract to design, build, and deliver
Advance payment received with balance due when delivery took place.
Taxpayer considered income when it delivered for both tax and financial purposes.
Decision: Service allowed (FSA 200246016)
Methods of Accounting – Cases & Rulings – 2
Goods mistakenly shipped and billed
Accrual basis taxpayer must recognize income when shipped. Any correction is generally made in the year in which it is determined.
If taxpayer has used this method for two or more years and wishes to now take corrections back to the year of the sale, they must file for a change in accounting method.
Accrual taxpayer would not include in income if amount is disputed by the customer. (Rev. Rul. 2003-10)
Methods of Accounting – Cases & Rulings – 3
Rotable spare parts may be treated as depreciable assets rather than as inventory held for sale. (Rev. Rul. 2003-37)
Completed contract method
Taxpayer transferred partially completed contracts to 4 C Corporations.
Subsequently incurred expenses related to these contracts and deducted them
Service disallowed the deductions as benefiting the C Corporation and was not a business expense of the S Corporation.
Decision - Tax Court agreed and was affirmed by the Circuit Court. (Bone v. Commissioner, (11 th Cir. 2003), aff’g T.C. Memo 2001-43)
Other Useful Information
News You Can Use
New Filing Address
Year-End Tax Planning Letter
Fee Schedules v. Hourly Rates
Industry/Functional v. Geographic Re-Alignment
Industry Audit Guides & Specialists
Offers in Compromise
Put the “Service” back in IRS
New IRS Circular 230
Code of Conduct
Doubling number of agents assigned to enforcement as of 3/9/03.
News You Can Use #1
Senate Probe Targets KPMG Shelters
IRS Issues New Guidelines for Charitable Organizations (Publications 4220 & 4221)
IRS May Share Data with INS
IRS Fines Taxpreparers $2.4M, But Doesn’t Collect (only 12% collected)
IRS Has ‘Material Weaknesses’ in Security Controls
News You Can Use #2
Federal Court Blocks Tax Avoidance Scheme – Colorado couple charged $1,595 fee to provide forms to remove TP form tax roles
IRS Expands Locations for Convention Expense Deductions
IRS Launches Online Tools to Help Access Client Information
2004 Standard Mileage Deduction $.375/mile in 2004