INC-centricity

Legal Tax Upstreaming

Blogger Diane Kennedy, a CPA who graduated from the University of Nevada, Reno wrote a recent post on her website, TaxLoopholes.com, about legally upstreaming income.  Diane points out several legitimate strategic uses of upstreaming strategies.  I will use her four stated uses, and add my own commentary:

1.    To upstream the income of a C corporation in your home state for the purpose of reducing state income tax.  For this have any benefit, the corporation must be generating sufficient “upstreamable” profits that justify the costs associated with making the strategy work.  It has to make sense financially.  We use a rule-of-thumb of 12:1 – for every $1 that the strategy costs you, you need to be able to upstream $12 to a state-tax-free jurisdiction to justify the expense.

2.     To divide out multiple streams of income within a company to separate active income from passive income.  This is particularly effective if your company has some active income that would be taxed at a lower rate, but where the more than 60% of income is passive, subjecting it to Personal Holding Company taxation on all income.

3.     To legitimize an asset protection plan.  In this scenario, the amount of “upstreamable” profits that exist are not really the deciding factor.  What DOES matter, is the value of the assets you are trying to protect.  When upstreaming to legitimize an asset protection plan, it is critical that the goods, services, or financing that is the basis of the commercial relationship between the two companies is REAL.  In other words, everything needs to be arm’s-length, and the services need to be provided; the products need to be real; or the loan must actually be funded – and repaid according to the terms of the agreement.

4.     To flunk controlled group issues for the purpose of implementing nondiscriminatory benefits.  This can be a sticky issue, and probably needs an attorney’s review before you run with it.

 

No matter what the strategy is, it won’t hold up unless it is completely verifiable, legitimate and documented.  And, the company that receives upstreamed funds must have a defensible nexus of operations in the target state.  Upstreaming demands crossing all your “t’s”.

Financial statements and Fundability

Disraeli once said that “there are three kinds of lies: lies, damned lies, and statistics.”

In business, some of the “statistics” that can tell such damning lies are the numbers found on company balance sheets and income statements.  Too often, the reality is not accurately reflected in the numbers.  Accounting is not intended to be a creative art, but in the hands of the right practitioner or aggressive entrepreneur, the accounting numbers can paint almost any type of picture.

Borderline - or worse - companies can be made to appear to be profitable.  Profitable companies can be made to look break-even or even appear to have losses.  But, there is a point at which the numbers - however they are painted - can impact your lend-ability as a company.  

If you are like many of our clients, you are using your Nevada corporation or LLC for a specific strategic advantage or benefit, it could be more likely that you could be using business practices that could negatively impact your lend-ability.

To illustrate, consider a fictional Nevada company as an example:  Tajax Industries is incorporated in Nevada and owned by James Smith.  The company imports raw materials that are sold to manufacturing companies in California.  In order to take advantage of a new market opportunity, Tajax needs additional funding in order to finance the purchase of additional product for importation.  James applies to an SBA lender bank for the financing, and provides all the documentation, including financial statements and tax returns.

The bank looks at the numbers and rejects the loan.  They determine the business is marginal at best, and is too high of a risk to qualify for the funding.  Mr. Smith objects, arguing that the business is a real money maker. 

Here are some of the things the bank might not have considered - some “damn lies” that were hidden by the statistics on the financial statements: 

1.   Mrs. Smith does all the accounting for the company.  A replacement would cost less than half of the salary paid to James’ wife.

2.  James Smith is paid a salary that exceeds fair and reasonable compensation.

3.  The business provides a lot of perks, paying for automobiles, insurance, medical expenses, travel, etc.

4.  The Smiths have a son away at college, who, despite not providing any actual services for the company, continues to draw a salary.

5.  Mr. Smith owns property in Nevada that Tajax leases, and pays double the fair market value in rent.

6.  All the financial reports are made on a cash-basis.  So, it doesn’t reflect sales based on credit, leaving out all the accounts receivable.

The bank does not look at these factors to make adjustments.  So, they determine that the business operates on a rate of return of 7.5% on investment capital.  Their research tells them that a business of this type and size should provide almost 20% return.  As a result, the loan is still considered a high risk, and value the business at worth $650,000.  No loan.

In another scenario, the same company hires a qualified accountant who looks at the business entirely differently.  He prepares a set of financial statements that reflect a number of adjustments to give a clearer picture of the reality of the business.  The rent is adjusted to fair market value; salaries are adjusted to fair market, and “reasonable”; the son is removed as an employee; the financials are reported on an accrual basis, significantly increasing the value of the business, and; the perks are adjusted to remove personal expenses.

After these adjustments, the financials tell an entirely different story.  Now the company shows a 19% rate of return on capital, the business is valued at $1.3 million, and the loan is approved.

So, when trying to access business credit, the “statistics” on your financial reports might be telling a different story than you expect.  Think through the “damned lies” that might be hiding in your financials before you submit loan applications to lenders.

You state tax bill is about to go up. Maybe WAY up.

The economic climate that individuals, corporations and businesses have been feeling has also hit state and local governments in a big way.  Most states will be addressing huge budget deficits during the 2009 legislative cycle with limited options. 

Although Nevada is one of the states with a budget deficit that must be resolved in coming months, Governor Jim Gibbons will introduce his budget this month without any new tax increases:  No corporate taxes, no personal income taxes, and no new property taxes.  Nevada’s Governor is, apparently, alone in his approach to dealing with budget problems.  He insists on cutting state spending until they meet the existing revenues.

Other states, however, are not so lucky.  Last month, the California legislature came dangerously close to circumventing constitutional protections against new taxes when Gov. Schwarzenegger refused to sign a bill with $9.3 billion in new taxes, disguised as “fees.”  The bill was given to Gov. Schwarzenegger for his consideration, even though the bill did not pass with the constitutionally-required two-thirds majority.

California has a real problem.  According to the non-profit Tax Foundation, California already has the third highest individual tax rate (topping out at 9.3%) described as “the most burdensome in the nation” - not counting an additional surtax of 1% for millionaires.  California’s business tax climate is equally bad - 47th in the nation - when factoring income, sales, unemployment insurance and property taxes.  The per capita tax burden in California is $5,028 - that is, for every man, woman and child!

This incredible tax burden is having its consequences - in a bad way.  Since the state imposed the additional 1% tax on incomes over $1 million, the number of millionaires in Los Angeles County alone dropped by 7,000 households.  During this same period millionaire households nationwide increased an average of 5.9%.  Where did these millionaires go?  Nevada has been one destination.

The coming year will see dramatic increases in the state taxes in many states.  The Washington Times reported that governors are proposing higher taxes on clothes, soft drinks, gasoline, auto registration, drivers licenses, and other items that impact low- and middle-income families.

In New York, Governor David A. Paterson has proposed a 137 new or increased taxes, including an 18% “anti-obesity tax” on non-diet soft drinks.  Other taxes and fees hit satellite TV, cigars, higher tuition fees, beer, car rentals, shoes and professional licenses.  Combined, these fees propose to raise $4 billion.

In Oregon, Gov. Kulongoski is balancing the budget on higher taxes for hospitals, health insurers, cigarettes, gasoline, vehicle registrations and corporations.  All totaled, at least 38 states are anticipating budget deficits totaling approximately $80 billion, with this number likely to grow.  The Center on Budget and Policy Priorities estimates that this number may reach $145 billion by 2010. 

According to the Cato Institute, “states should have been retrenching after budget increases of 7 percent over the last two years, but they repeated the same mistakes they made in the late ‘90s, assuming the good times were going to last forever.”   Chris Edwards, Director of Tax Policy Studies for the Cato Institute, points out that a report by the National Association of State Budget Officers showed that spending across the 50 states increased 6.5% in 2005, 8.7% in 2006, 9.3% in 2007 and 5.1% in 2008.

The real question is, how will the states close the gaps?  Unfortunately, those gaps are likely to be closed by raising your state tax bill.  This reality makes state tax planning an imperative part of your business strategy.  Now, more than ever, incorporating your business in Nevada makes economic sense.

California Democrats Propose $8.2 Billion Tax Increase

The State of California is in economic disarray. A conference committee on the state budget produced a spending plan that calls for an $8.2 billion tax increase, primarily on business and high income earners. It adds approximately $4 billion more in spending than the "Governator" recommended. Here are the highlights of the plan:

First IRS Revenue Ruling of 2008 liberalizes S Corp health insurance

Notice 2008-1 The IRS has released its first Revenue Ruling for the year 2008, which provides clarification for rules that allow a 2%-shareholder/employee to deduct accident and health insurance premiums. Accident and health insurance premiums paid or furnished by an S corporation on behalf of its 2-percent shareholders in consideration for services rendered are treated for income tax purposes like partnership guaranteed payments.

IRS has $110 Million in Refund Checks Looking for a Home

The Internal Revenue Service is looking for 115,478 taxpayers who are due refund checks worth about $110 million after the checks were returned as undeliverable. The refund checks, averaging about $953, can be claimed as soon as taxpayers update their addresses with the IRS. Some taxpayers have more than one check waiting.

Tax Rap

It is tax time!  We might as well try to find some humor and enjoyment in a sometimes difficult and distressing responsibility.  I see that Turbo Tax is doing a promotional contest using YouTube where contestants upload tax rap videos.  Here is one that I found entertaining.  Enjoy.

If you need some help getting your taxes prepared, contact our tax professionals at Integrated Tax Solutions.  Click here to get a free tax consultation with one of our experts.  It can't hurt!

When is a fee a fee, and a tax a tax?

One of the issues raised in the Northwest Energetic Services case mentioned in my last post, is the question of "when is a fee really a fee, and when is a fee really a tax?"

Norrthwest's attorney, Amy Silverstein, of Silverstein & Pomerantz, LLP in San Francisco, argued that the "fee" imposed by California was an attempt to replace lost revenue that the Legislature thought would occur with the passage of the California LLC Act in 1994.  Because the Legislature thought they would lose revenues due to the tax intricacies of LLC flow-through status, they had imposed two revenue-generating provisions:  an LLC annual "tax", and the LLC annual "fee".  But, just because it is called a "fee" doesn't make it a "fee".

A new development in tax nexus case law

Today I read an article about a recent legal decision in the case of Tax Commissioner of West Virginia v. MBNA America Bank, N.A. that is not just a little bit disturbing.  This case, which was filed November 21st of this year, flies entirely in the face of everything we thought we knew about the application of tax nexus rules across state lines.

The previous standard had been the landmark case of Quill v. North Dakota, in which the United States Supreme Court ruled that nexus only exists when the seller of tangible goods has a physical presence in that state.  Now, however, the MBNA case abandons the requirement that physical presence is required in order for a state to impose a tax. MBNA, one of the largest credit card issuers in the country, had no physical facilities, operations or employees in West Virginia.  It marketed VISA and Mastercard solicitations through the mail and by telephone from outside the state.

Even with these limitations, West Virginia ruled that MBNA is responsible to pay state corporate taxes on their WV-connected income.  This is going to create a tremendous fallout, and a domino-effect in many other states.  Ultimately, it will end up at the U.S. Supreme Court, which could take a couple of years.

Telephone Tax Refunds for Small Businesses

Last may, the IRS announced that it was to stop collecting federal excise tax on long-distance telephone service.  Since 1898, the IRS has collected a tax, which was 3% at the time, on all long distance communications.   Courts have ruled that long-distance communications of yesteryear are not the same thing today, and ruled that the tax is improper.  The result is that taxpayers can file for a refund of all federal telephone excise taxes paid after February 28, 2003, with interest

The IRS has published information to instruct and assist taxpayers on this issue:

1. Telephone Tax Refund Questions and Answers for Small Business and Tax-Exempt Organizations
2. IRS Announces Standard Amounts for Telephone Tax Refunds

As if you needed another reason for tax planning

The US Department of Treasury has published a one-page summary of impact that increased taxes will have on millions of Americans if permanent tax relief is not passed by Congress.  To summarize a summary, unless permanent tax relief is passed, by 2011:

• A family of four with two children making $60,000 in annual income today will pay 58% more taxes.  If the family makes $50,000 per year, the taxes will be 132% higher.
• 115 million taxpayers will average a tax increase of $1,716.
• 26 million small business owners will average a $3,637 tax increase

Employer-Paid Per Diem Expense Reimbursement Rules

The Internal Revenue Service today issued guidance emphasizing the need for employers to track the amount of expense reimbursement allowances paid to employees on a per diem basis.   Revenue Ruling 2006-56 tells employers that if they routinely pay per diem allowances in excess of the federal per diem rates, but do not track the allowances and do not require the employees either to actually substantiate all the expenses or pay back the excess amounts, and do not include the excess amounts in the employee’s income and wages, then the entire amount of the expense allowances is subject to income tax and employment tax. 

2006 Federal Tax Update Report available online

Samuel A. Donaldson, Associate Professor of Law at the University of Washington has published an abstract that explains the several developments in federal income, estate and gift taxes that effect individual and small business taxpayers.  His summary contains updated information covering a period from August 2005 through September 2006.  And, it is free, which is always good.

IRS Announces new mileage rules

Today, the Internal Revenue Service issued the 2007 mileage rates used to calculate the deductible costs of operating an automobile for business, charitable, medical or moving purposes. Starting January 1, the standard mileage rates for the use of a car (including vans, pickups or panel trucks) will be:

• 48.5 cents per mile for business miles driven;
• 20 cents per mile driven for medical or moving purposes; and
• 14 cents per mile driven in service to a charitable organization.

The standard mileage rates for business, medical and moving purposes are based on an annual study of the fixed and variable costs of operating an automobile.  As such, the mileage reimbursement has been increased to reflect rising gas prices. Runzheimer International, an independent contractor, conducted the study for the IRS.

See Revenue Procedure 2006-49 for further details.

Husband & Wife Ownership of LLCs in Community Property States

I am frequently asked about the impact of a husband and wife owning the membership interest in an LLC in a community property state.  It is and interesting issue that is unresolved in many respects.

Taxing Downloads

An interesting development in the area of state sales tax comes from the growing popularity of iTunes, and the anticipated rollout of Microsoft's equivalent service for the purpose of selling music and movies to the public.  In a nutshell, states are generally attempting every conceivable method of laying claim to tax revenue from these web-based transactions.  An analysis by CNET News last April revealed that 15 states and the District of Columbia all impose sales tax on digital media downloads.  And that number will likely rise.

S Election in Community Property states

The instructions to IRS Form 2553, Election by a Small Business Corporation, contains the following instructions about the required consent of shareholders:

Each shareholder consents by signing and dating either in column K or on a separate consent statement.  The following special rules apply in determining who must sign.

Tax Increase Prevention and Reconciliation Act

This from Jeff Haig, EA, MST who is a Tax Senior with Integrated Tax Solutions in Las Vegas:

As you probably know, the President signed the Tax Increase Prevention and Reconciliation Act into law on May 17, 2006. The new legislation also contains an assortment of business and corporate tax breaks, as well as some revenue raisers affecting business taxpayers. Here’s an overview of the provisions in the new law that directly impact business and what you need to know right now about this new law.

 

California attacking Montana LLC because manager is CA resident

The Board of Equalization has ruled that an LLC registered in Montana was doing business in California solely because the managing member was a California resident (Appeal of Mockingbird Partners LLC (May 17, 2006) Cal. St. Bd. of Equal. Case No. 306061). This is the second taxpayer to lose on this issue in the past few months and there are more cases to come.

GAO Chief warns that tax increases might be necessary

U.S. Comptroller General David Walker on December 12 opened a White House conference on aging with a warning that will be unwelcome to a president known for his tax-cutting ambitions: Raise taxes to avoid a fiscal meltdown.

A Frightening Nexus Development

The AP is reporting that the United States Supreme Court upheld a ruling by the California Supreme Court which allows a California man to sue a Nevada casino company in his home state for false advertising and deceptive business practices.  The California Supreme Court decision said that even though Harrah's Entertainment Inc. had no properties in California, it could be sued there because it advertised in California and received significant business from Californians.

Streamlined Sales and Use Tax Agreement takes effect

On October 1, 2005, the Streamlined Sales and Use Tax Agreement came into effect. Eighteen states had seats on the Governing Board at the launch, with a 19th state scheduled to join at the beginning of 2006. Businesses that have not previously been collecting sales and use taxes in these states can now register with the member states and receive an amnesty for past uncollected taxes.

Online help for understanding nonprofits

The IRS has published a helpful document called Life Cycle of a Private Foundation, that graphically outlines the steps and processes associated with becoming a non-profit foundation.  By clicking on the graphics in the document, the user is automatically sent to supporting informationa and documentation on the IRS website.  It is a pretty useful tool for individuals considering putting a non-profit together.

A Shark ate my Tax Return. Really.

If you're filing taxes late, here's one excuse you can try: A shark ate it!

Congress Passes the Katrina Emergency Tax Relief Act

On September 21 the House and Senate passed the Katrina Emergency Tax Relief Act of 2005. The $6.1 billion measure provides tax relief for individuals and businesses affected by the hurricane and incentives to promote charitable donations for victims. President Bush has promised to sign the bill as soon as he receives it.

Are Officer Salaries Mandatory?

I've been involved in a lengthy discussion/debate with several CPA's over the last week or so on the question of proper compensation for corporate officers and directors.  What had been presented to me as fact was the position that the IRS requires all corporate officers to take a salary.  I disagreed, and demanded the tax professionals who were advocating this position to provide me documentation that clearly proved that this was so.

IRS Issues Tax Guidance Plan for 2005-06

The Internal Revenue Service and Department of the Treasury released today the 2005-2006 Priority Guidance Plan, listing the tax issues that will be the subject of formal legal guidance during the next year.

Repeal of AMT introduced in US Senate

The chairman of the Senate Finance Committee has proposed the repeal of the Alternative Minimum Tax (AMT) this year, and expects to get widespread support in the Senate because it no longer services its original purpose and hits too many middle-class families.  However the Treasury Department says that it would be "too costly to repeal".  Naturally. 

Link: Grassley Urges Alternative Tax Repeal - Yahoo! News.

New Book on Tax Savings

The CPA firm of Moore, Kirkland and Beauston has announced the publication of America's Best Tax Strategies: Legitimate Ways to Save Income Taxes Now.  The book details strategies for real estate ownership and investment; tax-free compounding of investment income, and; strategies for business, including handling audits, frequent flyer miles, business autos, employing family, leveraging equity, benefiting from state income apportionment, dealing with double taxation, unreasonable compensation and asset protection.

IRS offers Free CD on IRA's and retirement planning

The IRS has prepared a free CD-rom on the use of IRA's in retirement planning, which it distributes at educational events across the country.  This CD guide contains information found in IRS Publication 4395, Individual Retirement Arrangement (IRA) Resouce Guide for Small Business Owners and Individuals. 

The CD provides information about traditional and Roth IRAs, as well as IRA-based retirement plans known  as SEP, SIMPLE IRA, SARSEP and Payroll Deduction IRA plans. It also contains video clips, FAQs, and calculators to provide ballpark estimates of retirement needs. 

Best of all, it is available free by calling the IRS Forms Distribution Center at 1-800-829-3676, select option 2, and request Publication 4395, or by clicking here.

IRS rebuts frivolous tax arguments

The IRS released a 56-page document titled "The Truth About Frivolous Tax Arguments".  It gives some detailed information regarding the official position of the Service on issues such as:

• the voluntary nature of the income tax
• the meaning of taxable and gross income
• Constitutional amendment claims
• frivolous arguments in due process collection cases

LLC Tax Basis

The concept of "tax basis" is used to determine if any taxable disposition of property creates a realized and recognized gain or loss.  Tax basis is frequently the the amount of cash  a person has invested in a piece of property, which may be adjusted by several factors.  A tax is generally due on the sale or exchange of prperty if the sale exceeds the tax basis in the property transferred.

For an LLC with flow-through taxation, basis is a very important consideration.  Members of an LLC can deduct certain losses of an LLC allocated to them to the extent of their tax basis in the their LLC interest (subject to a few limitations).  A member's tax basis can never be less than zero, even though it is not unusual to hear the term "negative basis" thrown around, which refers to a deficit capital account.

The tax basis of a member's LLC interest equals the amount of cash and property, with adjustments, that the member contributes to the LLC.   The tax basis also includes any portion of the LLC's liabilities, unless A) the debt is nonrecourse to that that member, but another member has personal liability for the debt, or B) the member is not at risk.

Accrued but unpaid expenses may be considered a liability that is allocated to ta member's basis if the LLC uses an accrual accounting method.  The IRS has also ruled that a short sale of securities is a liability that may increase each member's tax basis.

A liability is considered recourse for tax purposes if any member or related person bears the economic risk of loss for that liability.  Each member's share of the LLC's recourse liabilities is based on that member's economic risk of loss, so that generally a member bears the economic risk of loss to the extent that the member would be obligated to repay any of the LLC's creditors without receiving reimbursement.  If a debt is recourse against all members, then each member's share of the liability is included in their basis.

A nonrecourse liability is a debt for which the LLC member is not at risk or economic loss.  In this case, the basis attibuted to the debt is allocated to members according to their share of the LLC's minimum gain, with any balance allocated to members according to their share of distributed profits.

Charitable Giving Statistics

Americans give billions of dollars per year to charities.  In fact, charitable deductions in 2002 totaled over $136 billion.  According to the IRS Statistics of Income Bulletin (winter 2003-04), here are the average breakdown of claimed deductions for charitable contributions on 2002 tax returns:

• Taxpayers with Adjusted Gross Income between $15,000 to $30,000 averaged charitable contributions of $1,890.
• Taxpayers with AGI between $30,000 and $50,000 averaged $2,006 in charitable contributions.
• Taxpayers with AGI between $50,000 and $100,000 averaged $2,530 in charitable contributions.
• Taxpayers with AGI between $100,000 and $200,000 averaged $3,875 in charitable contributions.
• Taxpayers with AGI over $200,000 averaged $17,354 in charitable contributions.

The Kiddie Tax

Under current tax law, children under the age of 14 are taxed on "unearned income" (which includes dividends, interest, and gains from the sale of property) over a threshold amount of $1,600.  The tax rate is computed at their parent's top marginal tax rate.  This tax is intended to discourage and prevent abuse of income-shifting strategies by high income taxpayers.

In practice, the kiddie tax can create tax liabilities for industrious youngsters who earn money with a paper route or odd jobs, put their money into an account to save for college and earn interest on the balance.  The parents must file IRS Form 8615 for the child if the tax applies.  The parents may choose to report the child's income on their own return to eliminate the need to file the return for the child.  This election is made by filing Form 8814 with the parents return, but has some limitations on the type and amount of income the child has received.

To avoid the kiddie tax, professionals recommend that the child invest in tax-exempt or tax-deferred investments until the child turns 14, or hire the child in a family business so that the income is not "unearned" and thus not subject to the kiddie tax.

Dealing with medical expenses

Escalating medical costs leave even insured families left to cover increasing out-of-pocket costs.  While there are a number of strategies for small businesses and self-employed individuals to deduct the cost of health insurance coverage, the tax code also provides some relief allowing taxpayers to deduct medical costs.
Anyone who has prepared their own tax return is probably familiar with the rule that out-of-pocket deductions are generally only deductible if they exceed 7.5% of the adjusted gross income (AGI).  But for taxpayers who are subject to the Alternative Minimum Tax, medical expenses are only deductibe in excess of 10% of their AGI.  This means that many higher income taxpayers are unable to take any medical expense deduction.
One terrific, if under-utilized fringe benefit that the tax code allows is for the use of a Medical Reimbursement Plan by small business corporations.  If a corporation sets up an uninsured medical reimbursement plan to pay for non covered medical costs, the direct payment of medical expenses is not taxable to the employees for coverage for employees, spouses, and dependents.  The only exceptions to this rule are for owners of more than 2% of S corporation stock, and payment of expenses for domestic partners.  For the company providing the medical reimbursement, the payment of medical expenses are dedeductible from the first dollar.
I had a client several years ago who set up a Nevada corporation with my company so he could set up a Medical Reimbursement Plan to be able to deduct reimbursement expenses for his son's cancer treatment.  Even though he was a high income taxpayer, his uninsured expenses ran more than $25,000 per year.  His Nevada company provided a vehicle for him to not lose that deduction.

Avoiding Tax Penalties

Did you know there are more than 140 civil penalties in the Internal Revenue Code?  Many of these are designed to be stiff deterents to prevent certain acts or omissions.  Here are a few of the most common penalties: 

• FAILURE TO FILE A RETURN.  There is a 5% penalty for unpaid taxes per month (or fraction thereof) for failing to file a tax return.  The maximum penalty is 25%, with a minimum penalty of $100 or %100 percent of the required tax shown on the return if the return is not filed with 60 days, including extensions.  The $100 minimum penalty is not imposed if there is no underpayment of tax.

• FAILURE TO FILE ON TIME.  The penalty is .5% of the unpaid tax per month or fraction of a month, up to 25% of the tax.  If at least 90% of the tax is paid by the return's original due date, the penalty is waived.
• FAILURE TO PAY ESTIMATED TAX.  The IRS imposes a penalty which is the IRS rate of interest on the underpayments, which is adjusted quarterly.  This penalty is avoided for most individuals if they at least 90% of the liability for the current year, or 100% of the liability for the preceding year.  If your Adjusted Gross Income for the prior year is over $150,000 ($75,000 if filing separately), your safe harbor is 110% of the prior year's liability.
• FAILURE TO DEPOSIT TAXES.  Employers must deposit employment taxes on time, or suffer the consequences.  If you are not more than 5 days late, the penalty is 2% of the underpayment.  From 5 to 15 days late, the penalty is 5%.  More than 15 days late is a 10% of the liability.  If they have to send you a Notice and Demand for payment, it will cost you 15%.  This is a very expensive way to finance your employment taxes.  If you do it repeatedly, you will have to show up at the IRS offices and explain yourself.
• FAILURE TO WITHHOLD AND PAY TAXES WITHHELD FROM WAGES.  The IRS can collect taxes from the "responsible person" by means of a personal penalty, which is 100% of the emount of employment taxes required to be wittheld from wages.  A "responsible party" may be a corporate officer or other employees in position of authority.  This penalty cannot be discharged in bankruptcy.

What are "Start-Up" costs?

To the IRS, qualified start-up costs are those expenses that a business incurres while in the process of determining whether or not to start a new business, and which new business to begin.  This is often called the "whether or which test".  See IRS Rev. Rul. 99-23, 1999-1 CB 998.   Any expenses incurred after this decision is made are not considered part of the search and decision-making process, but are assumed to be used to consummate the transaction, and therefore they must be capitalized.

Start-up expenses are fully deductible up to $5,000, with any additional balance amortized over a period of 180 months.  Taxpayers make an election to amortize start-up expenses by attaching a statement to the initial tax return of the business.

"Economic Substance" doctrine outlined by IRS Chief Counsel

Small business is too frequently attracted to the promises made by promoters of tax shelters.  A casual revue of the press releases made by the Department of Justice reveals a pattern of promoters selling tax schemes to small business owners seeking to reduce their federal tax bill.  The IRS is cracking down on these practices, as evidenced by the publication of the "Dirty Dozen" abusive tax practices (which is due to be updated for the current year within a month or so).  The IRS, trying to educate tax professionals on these issues, is publicly discussing how decisions are made and what legal doctrines are used regarding the viability and legality of specific tax shelters.

On January 25, 2005, Daniel L. Korb, Chief Counsel for the Internal Revenue Service, addressed the University of Southern California 2005 Tax Institute in Los Angeles, and outlined the "economic substance" doctrine as defined in the courts regarding to the way the IRS views abusive tax shelters.  Korb was clear to state that the IRS does not seek to apply economic substance doctrine to every purported tax shelter case, but may seek to apply the doctrine in those cases where the tax code or internal regulations do not clearly address a particular tax shelter transaction.

The primary test for determining if economic substance exists is whether the transaction has "economic substance separate and distinct from the economic benefit achieved solely by tax reduction."  There is a two pronged test used by the IRS to see if these circumstances exist:

First, the transaction must be "rationally related" to the useful non-tax business purpose of the taxpayer that makes sense in light of the taxpayers conduct, practices and economic situation.

Second, the transaction must result in a "meaningful and appreciating" enhancement of value of the the business of the taxpayer - other than merely the reduction of taxes.

In Korb's remarks, he makes clear that different courts apply this two-pronged test differently, with some even ignoring the rigid requirements of the test altogether.  Anyone who has been involved in tax shelter investments, or is considering doing so, would be well advised to read Mr. Korb's remarks.

IRS warns of Tax Preparer Fraud

Heading into tax season, the Internal Revenue Service has published a warning regarding tax preparer fraud.  The Service cautions taxpayers to be wary of claims by preparers that offer larger refunds than other preparers, and reminds that tax evasion is a felony, punishable by five years imprisonment and a $250,000 fine.

Some suggestions:

• Avoid preparers who base their fee on a percentage of the refund.
• Use a reputable tax professional who signs your tax return and provides you with a copy for your records.
• Consider wither the preparer will be around in a few months or years to answer questions about your return after it has been filed.
• Don't sign the return until you understand all the entries.
• Never sign a blank tax form.
• Check on the preparers credentials.  There are several different levels of certified expertise, starting with an Accredited Tax Preparer, an Enrolled Agent, a CPA, a Licensed Public Account, and a Tax Attorney.  Only CPAs and Enrolled Agents may represent you before the IRS in all matters.  Other preparers may only represent taxpayers for audits only.

In Fiscal 2004, the number of criminal convictions almost doubled on fewer initiated investigations than the prior two years, with the average sentence running 19 months for tax evasion.

Federal Unemployment Tax figures for 2005

From Commerce Clearinghouse (CCH):  The taxable wage base under the Federal Unemployment Tax Act (FUTA) remains $7,000 for 2005. In addition, 49 of the 50 states, as well as the District of Columbia, Puerto Rico and the Virgin Islands, have received certifications for the maximum additional credit allowable based on the 12-month period ending on October 31, 2004, so that their employers pay FUTA taxes at the net rate of 0.8%. Only New York was unable to repay its obligations so its employers will pay FUTA taxes at the net rate of 1.1% in 2005. (Note: the certifications were actually given to all 50 states, but New York later determined that it would not qualify for the 2004 tax year.)

Taxable wage bases for 2005

Alabama ... $ 8,000 Alaska ... 27,900 Arizona ... 7,000 Arkansas ... 10,000 California ... 7,000 Colorado ... 10,000 Connecticut ... 15,000 Delaware ... 8,500 District of Columbia ... 9,000 Florida ... 7,000 Georgia ... 8,500 Hawaii ... 32,300 Idaho...? Illinois ... 10,500 Indiana ... 7,000 Iowa ... 20,400 Kansas ... 8,000 Kentucky ... 8,000 Louisiana ... 7,000 Maine ... 12,000 Maryland ... 8,500 Massachusetts ... 14,000 Michigan ... 9,000 Minnesota ... 23,000 Mississippi ... 7,000 Missouri ... 11,000 Montana ... 21,000 Nebraska ... 7,000 Nevada ... 22,900 New Hampshire ... 8,000 New Jersey ... 24,900 New Mexico ... 17,200 New York ... 8,500 North Carolina ... 16,700 North Dakota ... 19,400 Ohio ... 9,000 Oklahoma ... 13,800 Oregon ... 27,000 Pennsylvania ... 8,000 Puerto Rico ... 7,000 Rhode Island ... 16,000 South Carolina ... 7,000 South Dakota ... 7,000 Tennessee ... 7,000 Texas ... 9,000 Utah ... 23,200 Vermont ... 8,000 Virgin Islands ... 18,600 Virginia ... 8,000 Washington ... 30,500 West Virginia ... 8,000 Wisconsin ... 10,500 Wyoming ... 16,400

Delaware Passive Investment Companies Attacked

States continue to push the envelope past Constitutional limitations on their right to tax interstate commerce.  The latest news in this area deals with Delaware passive investment companies (PIC's), which have been designed and promoted to hold intellectual property such as patents, trademarks, and copyrights.  PICs are not involved in active trade or business, and are frequently used as subsidiaries of operating companies.  Because states want to cast as wide a net over business as possible in order to generate the most tax revenue, several states have now passed "Add-Back" legislation that, by statutory definition, redefines the use of any intellectual property as sufficient presence to create a tax nexus within that state. 

Sherwin-Williams, the paint company, has become the guinea pig for these laws.  The State of Massachussetts tried to assert tax authority over a Delaware PIC used by Sherwin-Williams an dwas turned back by the court.   But a couple of months ago the New York Tax Appeals Tribunal ruled that two PIC subsidiaries could be combined with the parent company for state tax purposes - which is a blatantly self-serving opinion coming from a state court.  In coming to their decision, the Tribunal decided that the administrative law judge at the Division of  Tax Appeals erred in relying on expert opinions.  (After all, who cares what tax experts think when there is an opportunity for a tax grab?)  It further ruled that the only reason that anyone would use a PIC is for tax avoidance.

This decision will probably now go to the US Supreme Court, in order to reconcile the pro-business Massachussetts decision and the tax-grab of the New York tax tribunal.  What have we come to when we have to rely on Massachussetts to defend what are essentially conservative constitutional principles?