October 2004

Fourth Quarter Planning

Planning and taking action in just a few areas could save you some money on your tax bill. If possible, consider some of the following:

• If you are not an owner-employee, consider the implications of receipt of that year-end bonus on your income for 2004. It may be worth your while to ask your employer to make the payment in 2005.
• Section 179 allows an expense for the 2004 tax year of up to $102k for vehicles over 6,000 pounds. For the tax year 2005, the maximum expense allowance is $25k plus normal depreciation.
• If you are self-employed, in some case it may be advantageous to bill customers in 2005 instead of December 2004.
• Consider timing of retirement distributions.
• Review your Flexible Spending account status.

Some tax breaks depend on your adjusted gross income (AGI). Consider the following options that could lower your AGI:

• Be sure to know if you qualify for an IRA deduction.
• If you have self-employment income, a profit sharing or 401k plan may be an option.

Please call our office to schedule an appointment if you would like further information to discuss your personal situation.

IRS Increases Interest Rates for 4th QTR 2004

The Internal Revenue Service announced this summer there will be a one percentage point increase in the interest rates for the calendar quarter beginning October 1, 2004. The interest rates are as follows:

• five (5) percent for overpayments (4% in the case of a corporation);
• 5% percent for underpayments;
• 7% percent for large corporate underpayments; and
• 2.5% percent for the portion of a corporate overpayment exceeding $10,000.

IRS Reviews Sub S Payroll for Officers

All owners of Subchapter S Corporations should be making wage payments to officers for 2004. The IRS is performing a review of all Sub S Corporations to make sure reasonable compensation is paid to owners for 2004. Although distributions are still allowable, distributions should be made in conjunction with wages.

IRS Continues to Review Exempt Organizations Compensation Practices

The Internal Revenue Service announced it will continue enforcement efforts into 2005 to identify and halt abuses by tax-exempt organizations that pay excessive compensation and benefits to their officers and other insiders.

As part of the Tax Exempt Compensation Enforcement Project, the IRS will contact nearly 2,000 charities and foundations to seek more information about their compensation practices and procedures.

The initiative will focus on particular areas including the compensation of specific officers and various kinds of insider transactions, such as loans and the sale, exchange or leasing of property to officers and others. The IRS will also focus on Form 990 reporting, including how organizations answered question 89(b) on their Form 990 — about excess benefit transactions — and other compensation information.

IRS Warns of New and Resurrected Scams

In an update of an annual consumer alert, the Internal Revenue Service urged taxpayers to avoid falling victim to one of a variety of new or existing schemes. Taxpayers who are victims of or suspect tax fraud can report it to the IRS at 1-800-829-0433.

Common schemes outlined by the IRS include:

Misuse of Trusts. Promoters of abusive tax transactions are increasingly urging taxpayers to transfer assets into trusts. The promoters promise a variety of benefits, such as the reduction of income subject to tax, deductions for personal expenses paid by the trust and reduction of gift or estate taxes. Taxpayers should be aware that abusive trust arrangements will not produce the tax benefits advertised by their promoters and that the IRS is actively examining these types of trust arrangements. More than a dozen injunctions have been obtained against promoters, and numerous promoters and their clients have been criminally prosecuted. Before entering any trust arrangements, taxpayers should seek the advice of a trusted tax professional.

"Claim of Right" Doctrine. In this emerging scheme, people file returns and attempt to take a deduction equal to the entire amount of their wages. The promoters advise them to label the deduction as "a necessary expense for the production of income" or "compensation for personal services actually rendered". The deduction is based on a complete misinterpretation of the Internal Revenue Code and has no basis in law.

Corporation Sole. The idea is that the arrangement entitles the individual to exemption from federal income taxes as a nonprofit, religious organization as described in tax laws. When used as intended, Corporation Sole statutes enable religious leaders - typically bishops or parsons - to become incorporated as individuals as a way of separating themselves legally from the control and ownership of church assets. But the rules have been twisted at seminars where promoters charge fees of up to $1,000 or more per person. Would-be participants are mistakenly told that Corporation Sole laws provide a "legal" way to escape paying federal income taxes, child support and other personal debts.

Offshore Transactions. Some people use offshore transactions to avoid paying United States taxes. Use of an offshore bank account, brokerage account, credit card, wire transfer, trust, offshore employee leasing or other arrangement to hide or underreport income or to claim false deductions on a federal tax return is illegal. A taxpayer involved in these schemes could be subject to payment of taxes, interest, penalties and potential criminal prosecution. This was the top scam in the 2003 "Dirty Dozen." A special program last year has yielded more than $170 million in taxes, interest and penalties, and the IRS and the states continue to aggressively pursue taxpayers and promoters in this area.

Employment Tax Evasion. The IRS has seen a number of illegal schemes that instruct employers not to withhold federal income tax or other employment taxes from wages paid to their employees. These schemes are based on an incorrect interpretation of "Section 861" and other parts of the tax law and have been refuted in court. Recent court cases have resulted in criminal convictions of promoters. Employer participants could also be held responsible for back payments of employment taxes, plus penalties and interest. Employees who have no withholdings are still responsible for payment of their personal taxes.

Improper Home-Based Business. This scheme purports to offer tax "relief" but in reality is illegal tax avoidance. The promoters of this scheme claim that individual taxpayers can deduct most, or all, of their personal expenses as business expenses by setting up a bogus home-based business. But the tax code firmly establishes that a clear business purpose and profit motive must exist in order to generate and claim allowable business expenses. This scam has been around for years, but the IRS continues to see activity in this area.

Frivolous Arguments. Frivolous arguments are false arguments that are unsupported by law. When a scheme promoter says "I don't pay taxes - why should you" or urges you to "untax yourself for $49.95," beware. The ads may claim that the promoter knows the "secret" for never paying taxes again, but that's just plain wrong. The U.S. courts have continuously rejected this and other frivolous arguments. Unfortunately, people across the country have paid for the "secret" of not paying taxes or have bought "untax packages." Then they find out that following the advice contained in them can result in civil and/or criminal penalties. Numerous sellers of the bogus schemes have been convicted on criminal tax charges. More than a dozen injunctions have been issued.

Identity Theft. Identity thieves use someone's personal data to steal his or her financial accounts, run up charges on the victim's existing credit cards, apply for new loans, credit cards, services or benefits in the victim's name and even file fraudulent tax returns. The IRS is aware of several identity theft scams involving taxes or the IRS. In one example, fraudsters sent bank customers fictitious bank correspondence and IRS forms in an attempt to trick them into disclosing their personal and banking data. In another, abusive tax preparers have used clients' Social Security numbers and other information to file false tax returns without the clients' knowledge. For taxpayers, it pays to be choosy about disclosing personal and financial information. And the IRS encourages taxpayers to carefully select a reputable tax professional.

Don't fall prey to a scam. If it sounds too good to be true, it probably is. If you think you're being scammed, report suspected tax fraud activity by calling 1-800-829-0433.

Sold or Planning to Sell Your Home?

In a healthy real estate market, make sure you are current on the tax implications if you are planning to sell or have sold your home. Here are some helpful Q&A to help you manage the process.

I sold my home last year. Do I have to report the sale?

Report the sale of your main home on your tax return only if you have a gain and at least part of it is taxable, or you have a gain and choose not to exclude it.

I sold my principal residence this year. What form do I need to file?

If you meet the ownership and use tests, you will generally only need to report the sale of your home if your gain is more than $250,000 ($500,000 if married filing a joint return). This means that during the 5-year period ending on the date of the sale, you must have:

• Owned the home for at least 2 years (the ownership test), and
• Lived in the home as your main home for at least 2 years (the use test). If you owned and lived in the property as your main home for less than 2 years, you may still be able to claim an exclusion in some cases. The maximum amount you can exclude will be reduced.

If you were on qualified extended duty in the U.S. Armed Services or the Foreign Service you may suspend the five-year test period for up to 10 years. You are on qualified extended duty when:

• At a duty station that is at least 50 miles from the residence sold, or
• When residing under orders in government housing, for more than 90 days or for an indefinite period.

This change applies to home sales after May 6, 1997. You may use this provision for only one property at a time and one sale every two years.

If I sell my home and use the money I receive to pay off the mortgage, do I have to pay taxes on that money?

It is not the money you receive for the sale of your home, but the amount of gain on the sale over your cost, or basis, that determines whether you will have to include any proceeds as taxable income on your return. You may be able to exclude any gain from income up to a limit of $250,000 ($500,000 on a joint return in most cases). If you can exclude all of the gain, you do not need to report the sale on your tax return.

If I take the exclusion of capital gain tax on the sale of my old home this year, can I also take the exclusion again if I sell my new home in the future?

With the exception of the 2-year waiting period, there is no limit on the number of times you can exclude the gain on the sale of your principle residence so long as you meet the ownership and use tests.

What is the amount of capital gains from the sale of a home that can be excluded if sold in less than the two year waiting period?

If you owned and lived in the property as your main home for less than 2 years, you may still be able to claim an exclusion in some cases. The maximum amount you can exclude will be reduced.

You can claim this reduced exclusion if either of the following is true.

(1) You did not meet the ownership and use tests on a home you sold due to:

• health reasons
• a change in place of employment
• to the extent provided by regulations, unforeseen circumstances. (see below)

(2) Your exclusion would have been disallowed because of the rule on selling more than one home in a two year period, except you sold the home due to:

• health reasons
• a change in place of employment
• to the extent provided by regulations, unforeseen circumstances.

For more information, you can reference IRS Publication 523, Selling Your Home

Recap of "Catch-Up" Provisions:

• Participants in 401(k), 403(b), SEP or 457 plans, age 50 and above, are permitted to contribute an additional pre-tax amount (a "catch-up" contribution), under Code section 414(v). The otherwise applicable contribution limit on elective deferrals is replaced with a higher limit for such individuals. However, it is an optional provision that first must be elected by the plan sponsor (employer). Starting generally at an additional $3,000 in 2004, the amount increases to an additional contribution of $5,000 in 2006. The eventual $5,000 "catch-up" contribution limit will be indexed for inflation in $500 annual increments, beginning in 2007.
  
  
• There are parallel provisions for SIMPLE plan participants. Under a SIMPLE plan (Code Section 408(p)(2)(A)), the "catch-up" contribution is an extra $1,500 for 2004. The eventual $2,500 "catch-up" contribution limit will be indexed for inflation in $500 annual increments in 2007 and thereafter. Importantly, these "catch-up" contribution opportunities were not available to employees until calendar year 2002 and after.

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