Archive for July, 2002

RING AROUND THE ROSEY FAILS AN S CORPORATION SHAREHOLDER

Wednesday, July 31st, 2002 by Joe Kristan

Entrepreneurs often set up a new S corporation every time they set up a new business. The attorney gets to fill out a new set of corporate organization documents, the accountant gets to do a new tax return, and the client gets to isolate each business from the potential lawsuits of each other business. The whole team wins!
Unless, of course, one of these businesses loses money. S corporation shareholders can only deduct losses to the extent of their basis in the S corporation stock, plus their basis in any direct loans made to the S corporation. (S corporations do not pay taxes on their earnings; their shareholders instead report the income or loss on their individual 1040s. To learn more about S corporations, click here.) This basis is reduced by taxable losses; when an S corporation is thinly capitalized, basis can disappear quickly.
GAMES PEOPLE PLAY. Sometimes taxpayers only find out that they are out of basis at tax time. If they are counting on their S corporation losses to reduce their taxes, they can get very upset. They can also get imaginative. They may imagine, for example, that they borrowed money from their profitable S corporations before year-end and loaned it back to the loss corporation. They then prepare their tax returns deducting losses against their imaginary basis. The technical name for this technique is ?fraud.?
Wiser taxpayers arrange for sufficient basis before year-end. Donald G. Oren, a Minnesota trucking company entrepreneur, recently learned the hard way how difficult this can be to accomplish. Shortly before the end of the tax year, the shareholder borrowed money from his profitable S corporation, Dart Transit Co., and loaned it to his loss S corporation, Highway Leasing. The loss corporation then promptly loaned the funds directly back to the profitable S corporation ? closing the circle and getting the cash right back where it started.
SO WHAT?S THE PROBLEM? The taxpayer did everything the right way in executing the transactions. He had checks written, rather than simply making bookkeeping entries. He had notes executed, and he completed all of the transfers before year-end. The Tax Court said this wasn?t enough. The court said that the circle of money and loans ? from the profitable corporation to the taxpayer to the loss corporation and back to the profitable corporation ? had no substance. And even if there was substance, said the court, the loan wasn?t ?at-risk,? so it would not be available to allow a loss deduction.
WHAT DOES THIS CASE TELL US? Taxpayers with multiple controlled S corporations need to be very careful how they get basis for losses. In many cases, the best solution is to put controlled S corporations into a single S corporation holding company ? an option that was unavailable in the tax years covered in this case. Such a holding company structure can be treated as a single S corporation with a single basis, avoiding the need to move funds around when one corporation has losses. This idea also works using LLCs; in both cases, each business is protected from liabilities of the others.
Where a common holding company structure is impractical, taxpayers should first use funds from their personal resources to fund S corporation losses. If they must use funds from other S corporations, they should consider having the profitable corporation make distributions to the shareholders, rather than loans; distributions of S corporation earnings are generally tax-free. The shareholders should consider contributing funds to the loss corporation as capital, rather than as debt. The loss corporation should refrain from loaning the injected funds back to the profitable corporation.
IS THIS THE LAST WORD? Mr. Oren will owe nearly $5,300,000 in additional federal taxes and an unknown amount of state taxes if this case is not reversed on appeal. An appeal seems likely.

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LIFE INSURANCE VEBA TAKES A HIT

Wednesday, July 31st, 2002 by Joe Kristan

An appeals court has upheld the IRS in striking down the use of a VEBA (Voluntary Employee Beneficiary Association) to provide tax-free benefits to highly compensated executives. The case (Neonatology Associates, PA, CA-3, #01-2862, 7/29/02) involves a setup where a professional medical corporation attempted to deduct contributions to a VEBA to buy life insurance. The contributions were far in excess of the cost of coverage, creating cash reserves that the doctors could purportedly withdraw tax-free.
The appeals court sustained the Tax Court ruling that the doctors? corporation could only deduct payments up to the cost of term life coverage. The cost of term coverage was a small fraction of the amount contributed. The approximately $1,000,000 in excess of the cost of term insurance was treated as dividends — non-deductible to the corporation, but taxable to the doctors. The doctors were also hit with penalties; the court ruled that the doctors could not reasonably rely on tax representations made by the insurance sellers who promoted the plan.
We hope to discuss this case more in a future Tax Update. In the meantime, approach VEBA life insurance schemes with the same respect you would give to wealth-generation opportunities on unsolicited faxes from Nigeria.

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APPLICABLE FEDERAL RATES FOR AUGUST 2002 ARE OUT

Wednesday, July 31st, 2002 by Joe Kristan

The IRS has issued the minimum rates to be charged for loans made in August 2002:

  • Short Term (demand loans and loans with terms of 1-3 years): 2.44%
  • Mid-Term (loans from 3-9 years): 4.24%
  • Long-Term (over 9 years): 5.6%

All historical AFRs are available through the links page.

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SEARCHING FOR A SILVER LINING IN THE STOCK MARKET

Wednesday, July 24th, 2002 by Joe Kristan

Many of us lately find ourselves holding shares of stock that are worth, well, somewhat less than what we paid for them. In some cases, the only value remaining in our investment is our potential tax deduction. Perhaps we may use our losses to avoid paying tax on the massive gains we recognized when we bailed out of our WorldCom shares last January.
A loss on a sale of stock is a capital loss. Such losses are fully deductible to the extent of capital gains; individuals can deduct an additional $3,000 per year. Individuals can carry unused capital losses forward indefinitely. Corporations can carry such losses back three years and forward five years.

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TIMING IS EVERYTHING

Wednesday, July 24th, 2002 by Joe Kristan

The ?wash sale? rules disallow losses if the same stock is bought within 30 days before OR after the loss sale. If you think, for example, that WorldCom is a screaming buy today, but you would like to deduct your losses on the WorldCom stock you sold yesterday, make sure 30 days have passed before you buy more WorldCom shares.
For most stock positions, the ?trade date? is the effective date of a stock sale for tax purposes. For ?short? positions sold at a loss, however, the ?settlement? date is the effective date. At this point, the problem of losses on short positions is only theoretical, as they can only occur if a stock price rises.

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DON?T SELL TO A RELATIVE?

Wednesday, July 24th, 2002 by Joe Kristan

?because losses on sales to related parties are nondeductible.

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IRS ELIMINATES SOME FORM 5500 FILINGS

Wednesday, July 24th, 2002 by Joe Kristan

Certain fringe benefit plans are no longer required to file Form 5500 as a result of a recent IRS notice. The Notice (Notice 2002-24) eliminates the Form 5500 filing requirement for small cafeteria plans, dependent care plans and adoption assistance plans. The notice is effective for any returns not yet filed, including overdue returns.

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WHAT PLANS CAN SKIP FORM 5500?

Wednesday, July 24th, 2002 by Joe Kristan

Plans excused from filing Form 5500 include:

  • Cafeteria plans with fewer than 100 participants
  • Educational assistance plans with fewer than 100 participants
  • Other unfunded ?welfare benefit plans? with fewer than 100 participants that are either (1) fully-insured; (2) payable out of general employee assets or employee contributions; (3) a combination of (1) and (2).

Welfare benefit plans are those providing (whether or not using insurance) medical benefits, accident or death benefits, vacation benefits, employee apprenticeship and training programs, group legal plans and day-care services. The most common welfare benefit, of course, is health coverage.

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WHAT KINDS OF PLANS STILL HAVE TO FILE FORM 5500?

Wednesday, July 24th, 2002 by Joe Kristan

Form 5500 is still required of many plans. For example, pension and profit sharing plans, including 401(k) plans, have to file Form 5500. So do health plans and other welfare plans, if they cover more than 100 participants. They are generally due on the last day of the seventh month after the end of the plan year. If the plan and the plan sponsor have the same plan year, the plan return due date is automatically extended if the sponsor?s tax return is extended.
Of course, recreational preparation of unnecessary 5500s is still permitted, but don?t show them to anyone.

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NEW HEALTH PLAN ALLOWS EMPLOYEES TO CARRY OVER REIMBURSEMENT DOLLARS

Friday, July 5th, 2002 by Joe Kristan

The IRS has just blessed a new type of employer heath plan that permits employees to carry over unused reimbursement dollars from one year to the next, and even into retirement.
There is one catch: the employer must fund the reimbursement account. Employee dollars cannot be used.
The plan approved by the IRS in Rev. Rul. 2002-41 features high-deductible health insurance, accompanied by individual employer-funded reimbursement accounts (?health reimbursement arrangements,? or HRAs) that employees can tap to cover deductibles and other out-of-pocket medical expenses. If an individual does not use his entire employer HRA contribution in a given year, it carries over to subsequent years. The HRA may also allow unused amounts to be tapped for documented medical expenses after retirement. Cash withdrawals, however, are not available.
The HRA plan in Rev. Rul. 2002-41 resembles a Medical Savings Account (MSA) in some respects. It is designed to reduce total health costs by giving the participants responsibility for more expenses, accompanied by an opportunity to build up an account for retirement health costs. In a companion announcement (Notice 2002-45), the IRS makes clear that the employer-funded accounts may be used with a more conventional health plan.
This plan is likely to be carefully evaluated by employers if the reduced premium costs available using high deductible plans offset the need to make employer contributions to the HRA. As these plans lack the bureaucratic red tape found in MSAs, they might become more popular.

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WHAT IS THIS MSA STUFF?

Friday, July 5th, 2002 by Joe Kristan

A Medical Savings Account is an individual IRA-like account that can be opened in conjunction with a qualifying employer-sponsored or self-employed health insurance plan. For family coverage, the plan deductible needs to be between $3,300 and $4,950, with an out-of-pocket maximum of no more than $6,050. These amounts are lower for single-person coverage.
Individuals can make tax deductible contributions to their MSA; the maximum 2002 contribution is $3,712.50 (75% of the maximum allowed deductible). They can withdraw amounts tax free up to the amount of out-of-pocket expenses. Amounts not withdrawn accumulate on a tax-deferred basis and can be withdrawn at retirement much like IRAs.
The concept is a small-scale version of a typical self-insured corporate health plan, where the company pays health-claims out of its own funds but maintains a stop-loss for major claims. The MSA is conceptually a personal self-insurance reserve. As a practical matter, MSA participants often allow their MSA contributions to accumulate and pay their medical expenses using other funds; this allows MSA funds to accumulate tax-free.
MSAs are available only to self-employed individuals or small plans. To learn more, visit: http://moneycentral.msn.com/articles/insure/health/1423.asp

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IRS TO START PARTNERSHIP MATCHES?

Friday, July 5th, 2002 by Joe Kristan

The IRS has a surprise in store for many partners and S corporation shareholders. Perhaps sensing that not all income reported to partners and shareholders on their K-1 forms is being properly reported, the IRS recently announced that it will start automatically matching partners and their K-1s. According to an IRS spokesman, the IRS will match data from up to 16.8 million K-1 forms filed for 2001.
Anecdotal evidence suggests that not all K-1 income is punctiliously reported. Experience suggests automated matching can improve compliance a lot. For example, when dependent social security numbers were first matched on Form 1040, millions of dependents mysteriously vanished from tax returns filed the following year. Absent a mass alien abduction, we can assume that the matching program for the dependent social security numbers was responsible.

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?BUT NOT THIS KIND OF PARTNERSHIP

Friday, July 5th, 2002 by Joe Kristan

The Seventh Circuit Court of Appeals recently upheld a Tax Court decision denying ?Married Filing Jointly? status to a male couple (Robert D. Mueller v. Commissioner) The court held that as the couple was not married pursuant to governing state law (Illinois), the partnership was ineligible to file a joint return. The court declined to allow joint filing status for the partners under a constitutional ?equal protection? argument.

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